- How prices are set
- Bid & Ask
- Stock order types
- Technical Analysis
- Fundamental Vs. Technical Analysis
Stock prices are a function of supply and demand.
As buyers move into the market, demand grows faster than supply and the price goes up. Sometimes supply and demand find a balance, which is a price that buyers accept and sellers accommodate. When supply and demand are roughly equal, prices will bounce up and down, but in a narrow price range. It is possible for a stock to stay in this range for days or months, before something else disrupts the balance.
If demand for a stock exceeds the supply, its price will rise. However, it will only rise to point where buyers suspect demand is waning.At that point, holders of the stock will sell. Some may have ridden the price up and believe a reversal is coming so they take their profits and sell.As more owners sell (for whatever reason), the price begins to fall, since there is now more supply than demand. To entice a buyer, the holder of the stock lowers the price.
The same dynamic works on the other side, but in reverse. As the price falls, it will reach a level that buyers find attractive. As buyers acquire shares, the stock’s price rises since sellers must be enticed to let go of their shares.
This dynamic of supply and demand is the most important truth investors need to learn about stock prices. While investors may want to assign a value to a stock, it is the market and the give and take between supply and demand that sets the price.
If you have access to the proper online pricing systems, you can see the bid and ask prices. The Nasdaq structures its pricing around the bid-ask. You will notice that the bid price and the ask price are never the same. The ask price is always a little higher than the bid price.
What this means is if you are buying the stock you pay the ask price (the higher price) and if you are selling the stock you receive the bid price (the lower price).
The Bid/Ask Spread
What happens to the difference between the two prices? This difference is the spread and it is kept as profit by the broker/specialist handling the transaction. In truth, the spread goes to pay a number of fees in addition to the broker’s commission. Note: This is not the same commission you pay a retail broker. Because prices move constantly, especially for actively traded stocks, you can’t know what price you will get if you are a buyer or a seller unless you use specific market orders.
The market order is the simplest and quickest way to get your order filled (or completed). A market order instructs your broker to buy or sell the stock immediately at the prevailing price, whatever that may be. If you are following the market, you may or may not get the last price listed. In a volatile market, you will probably get a price close to that, but there is no guarantee of any specific price. One final, but important note: Market orders will likely be the most inexpensive of the orders you place.
Limit orders instruct your broker to buy or sell a stock at a particular price. The purchase or sale will not happen unless you get your price. Limit orders give you control over your entry or exit point by fixing the price, which can be helpful. However, you may want to do some math first. Check with your broker to see how the commission on limit orders compares with what you pay for market orders. If there is a significant difference, you may be better off with a market order (assuming the price is at or near your target) and saving on commissions.
Stop Loss Orders
A stop loss order gives your broker a price trigger that protects you from a big drop in a stock. You enter a stop loss order at a point below the current market price. If the stock falls to this price point, the stop loss order becomes a market order and your broker sells the stock. If the stock stays level or rises, the stop loss order does nothing. Stop loss orders are cheap insurance that protects you from a loss.
The trailing stop order is similar to the stop loss order, but you use it to protect a profit, as opposed to protect against a loss. If you have a profit in a stock, you can use the trailing stop order to follow it up. You enter the trailing stop order as a percentage of the market price. If the market price declines by that percentage, the trailing stop becomes a market order and your broker sells the stock. If the stock continues to rise, the trailing stop follows it up since it is a percentage of the market price. This protects your additional gains.
Good Till Canceled
A Good till canceled order instructs your broker to keep the order active until you cancel it. Obviously, you use this order with other order types to specify a time frame for the order. Some brokers have limits on how long they will hold a GTC order.
A day order is any order that is not a good till canceled order. If your broker does not fill your order that day, you will have to re-enter it the next day.
All or None
The all or none order states you want the entire order filled or none of the order filled. You would use this type of order for thinly traded stocks.
Just as there are many investment styles on the fundamental side, there are also many different types of technical traders. Some rely on chart patterns, others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts’ exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don’t care whether a stock is undervalued – the only thing that matters is a security’s past trading data and what information this data can provide about where the security might move in the future.
The field of technical analysis is based on three assumptions:
1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.
1. The Market Discounts Everything
A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock’s price reflects everything that has or could affect the company – including fundamental factors. Technical analysts believe that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.
2. Price Moves in Trends
In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Most technical trading strategies are based on this assumption.
3. History Tends To Repeat Itself
Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.
Charts vs. Financial Statements
At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements. (For further reading, see Introduction To Fundamental Analysis and Advanced Financial Statement Analysis.)
By looking at the balance sheet, cash flow statement and income statement, a fundamental analyst tries to determine a company’s value. In financial terms, an analyst attempts to measure a company’s intrinsic value. In this approach, investment decisions are fairly easy to make – if the price of a stock trades below its intrinsic value, it’s a good investment. Although this is an oversimplification (fundamental analysis goes beyond just the financial statements) for the purposes of this tutorial, this simple tenet holds true.
Technical traders, on the other hand, believe there is no reason to analyze a company’s fundamentals because these are all accounted for in the stock’s price. Technicians believe that all the information they need about a stock can be found in its charts.
Fundamental analysis takes a relatively long-term approach to analyzing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years.
The different timeframes that these two approaches use is a result of the nature of the investing style to which they each adhere. It can take a long time for a company’s value to be reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock’s market price rises to its “correct” value. This type of investing is called value investing and assumes that the short-term market is wrong, but that the price of a particular stock will correct itself over the long run. This “long run” can represent a timeframe of as long as several years, in some cases. (For more insight, read Warren Buffett: How He Does It and What Is Warren Buffett’s Investing Style?)
Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of time. Financial statements are filed quarterly and changes in earnings per share don’t emerge on a daily basis like price and volume information. Also remember that fundamentals are the actual characteristics of a business. New management can’t implement sweeping changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyze a stock is generated much more slowly than the price and volume data used by technical analysts.
Trading Versus Investing
Not only is technical analysis more short term in nature that fundamental analysis, but the goals of a purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used for a trade, whereas fundamental analysis is used to make an investment. Investors buy assets they believe can increase in value, while traders buy assets they believe they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does characterize a difference between the two schools.