3. Supply, demand and price: why it rises and falls constantly
Theory 1: How the market really works
A company reports excellent quarterly earnings, better than last year's in absolute terms. That same day, its share price falls.
Now for the question that genuinely obsesses anyone looking at a price chart. Why does the price go up and down, sometimes several times per second, when apparently nothing has happened at the real company?
The mechanism: two groups of impatient people
The short answer is the oldest one in economics: supply and demand. At any given instant there are people who want to buy a particular share (demand) and people who want to sell it (supply).
When more people want to buy at the current price than want to sell at that same price, the price rises. The most impatient buyers start offering a little more to persuade someone to sell to them.
When the opposite happens, and more people want to sell than to buy at the current price, the price falls. The most impatient sellers lower their price to find a buyer.
Out of that comes the most honest definition of all. The market price at any moment is, quite literally, the point at which the last buyer and the last seller agreed.
Why the appetite to buy or sell changes
That explains the mechanism, but leaves the more interesting question open: why does people's willingness to buy or sell change in the first place? This is where expectations come in.
Unlike the price of a loaf of bread, the price of a share does not only reflect what the company is worth today. It reflects what thousands of buyers and sellers, collectively, believe the company will earn in the future.
Which brings back the scene we opened with. A company reports excellent earnings, better than last year in absolute terms, and its price still falls that same day. If the market expected even stronger growth, the surprise is negative relative to expectations, even though it is positive relative to the past.
This is one of the first mental traps to overcome. The price does not react to 'how the company is doing' in absolute terms: it reacts to the gap between what happened and what the market had already anticipated would happen.
Why it moves even when there is no news
This dependence on expectations also explains why the price moves constantly even when there is no relevant news about the company. New information keeps arriving from other sources:
- About the economy in general: interest rates, inflation, employment data.
- About the sector: what a competitor has said.
- About overall market sentiment.
- Or liquidity simply flows in and out as large funds rebalance their portfolios.
Each of those pieces of information can change, however slightly, what someone is willing to pay or accept. And the price adjusts.
Price is not value
It is essential to separate two concepts that beginners constantly confuse: price and value.
Price is an objective fact. It is the exact figure at which the last trade was crossed, and anyone can look it up.
Value, or 'intrinsic value', is a subjective and debatable estimate of what a company 'should' be worth given its fundamentals: its earnings, its assets, its expected growth.
The consequence is uncomfortable. Two analysts can look at exactly the same data for the same company and arrive at completely different value estimates, because doing so requires assumptions about a future nobody can know for certain.
Price, by contrast, admits no argument. It is what it is at every instant, because it is simply the outcome of the last agreement between one specific buyer and one specific seller.
Much of active investing — and of the algorithmic trading we will cover later in this course — comes down, at bottom, to one of two bets:
- That the price will, at some point, converge toward what you believe the real value is.
- Or that there are statistical patterns in how the price moves, exploitable without even needing an opinion about value.
Volatility: how much it moves, not which way
Finally, it is worth introducing the word that sums up all this constant movement: volatility.
Volatility measures how much and how often the price of an asset moves over a given period. A stock that moves 0.1% up or down each day is not the same thing as one that can move 5% in either direction.
Neither high nor low volatility is 'bad' in itself: it depends on the strategy you want to apply. But it is impossible to understand the risk of an investment, or to design a sensible algorithmic strategy, without first measuring how much the price of the asset you are trading usually moves.
The same fall means two different things
An example helps fix the idea. Imagine a stock that typically moves between -0.5% and +0.5% a day. If on one particular day it falls 4%, you know immediately that something out of the ordinary has happened at that company.
But suppose that same 4% drop in a stock that routinely moves 3-4% on any given day of the week. There the alarm signal is much weaker: it is part of its normal behavior, not an anomaly.
A price move has to be compared against its own usual volatility, not against a fixed number applied to every stock alike. It is one of the first habits that separates an analyst with judgment from someone who only reads the headline.
We will return to volatility, in more depth, in the level devoted to risk and return.