How Does a Market Work?

To understand the principles of technical analysis, we must be familiar with how markets work and who the players might be. To better understand how market prices are set, let us begin with a hypothetical trading example. Let us assume that we are watching the trading post on the New York Stock Exchange where the stock of an imaginary company International Business Products (IBP) is being traded during normal trading hours.

Assume that a specialist who has an interest in the stock of IBP is present; this specialist’s job is to stabilize the price of IBP’s stock. In addition, several floor traders are present; these floor traders represent off-floor interests in the stock. The first off-floor interest is a mutual fund that wants to purchase the stock because its analyst believes the company’s earnings are going to rise suddenly and rapidly. The analyst has determined this expectation from studying the financial statements of IBP and from interviewing IBP’s management. The second off-floor interest is a group of investors from a golf club in New Jersey who have heard of the profits one member of the club has gained from buying IBP earlier in the year. They also are interested in buying the stock but have no other information than what they have heard about their friend’s profits. The third off-floor interest is a pension fund that currently owns IBP stock. This pension fund has made a substantial profit in IBP but now wants to sell its holdings because it has determined that the stock is overpriced. The fourth off- floor interest is an estate that owns the stock and needs to liquidate the position to raise cash to pay taxes. The fifth off-floor interest is a hedge fund that has been watching the stock price change and is flexible enough to either buy or sell shares but has no particular opinion about the prospects for the company.

Thus, the players in this hypothetical marketplace can be summarized as

• A specialist whose job is to stabilize the price of IBP
• A mutual fund that desires to accumulate shares of IBP because it believes the earnings of IBP will improve rapidly
• A group of investors acting on the fact that IBP’s stock has risen in the past
• A pension fund that already owns shares of IBP and believes the current price is too high
• An estate that owns shares of IBP and must sell them to raise cash
• A hedge fund that is attempting to trade the shares of IBP but has no opinion about the prospects for IBP as a company

Notice that the players have different sources of information, different interpretations of that information, different reasons for trading IBP’s stock, different time horizons, and different expectations. The mutual fund believes in the analyst’s recommendation that the prospects for the company will improve immediately and wants to buy because it expects the price to rise. On the other hand, the pension fund believes the price of the shares is already too high and wants to sell, not necessarily because it expects the price to decline but because the possibility of future rises is diminishing. One or the other will end up correct, depending on how the stock performs in the future. In addition to these major players is the estate that wants to sell the stock to raise cash. It has no interest in the company and only wants the money from the sale. Its information is the necessity to raise cash and its interpretation is to sell the stock. The specialist may have an opinion and expectations about the company, but his responsibility is to stabilize the market for its shares. He will step in and buy or sell to provide liquidity and to keep the share price from rising or declining sharply. He will thus be acting contrary to the direction of the stock price, buying when it dips and selling when it rallies. The hedge fund will try to take advantage of anomalies, times when the stock seems to be out of balance with either its trend or its value. Finally, the golf club members are interested in buying the stock only because someone they know has made money in it. They expect to realize a sizable profit.

These different types of players are just examples. In real markets, of course, the number of players is huge, and information and interpretation of that information are equally as vast. Players buy and sell based on their interpretation of information. In some cases, that information might have nothing to do with the company and might not even be accurate. The estate sale, for example, is based on information that the estate needs cash, and the golf club members are buying stock purely on the information that someone else has made money in it. It is possible that the estate does not need the cash or that the member claiming the outstanding profit is lying. Players might interpret the information incorrectly; they might not care about the company at all; or they might act strictly emotionally, based on either greed or fear (in the case of a sudden and unexpected decline). The net result is a transaction between opposing players at a specific price. That price reflects the sum of all the information and interpretation by all players at that instant in time.

Now what happens to that price when the players interact over time? Obviously, each new price reflects a new sum of interpretation. Say the last price of IBP was $50.00. The mutual fund is anxious to buy the stock and bids 50.00 for 20,000 shares. The pension fund, not being as anxious, offers 10,000 shares at 50.40 and 10,000 shares at 50.60, all it has to sell. This is a standoff because a new price has yet to be established. The specialist, judging that the spread between the bid and offer is too wide and surmising from his information that the buyer is larger than the seller, offers 1,000 shares at 50.10 because he cannot outbid the buyer above the last price. At the same time, the golf club members enter an order to buy 1,000 shares at the market. This trades at 50.10 against the specialist’s offer. Now a new price has been established at 50.10, higher than the previous price of 50.0. The sum of all expectations has changed slightly to the upside. Now the estate comes in and sells its 10,000 shares at the market, which is the 20,000-share mutual fund bid at 50.00. The new price is back to 50.00 on higher volume. The hedge fund, seeing that the 10,000 shares were easily traded at 50.00, believes there is a large buyer at 50.00 and buys the pension fund’s 10,000 shares at 50.40. Remember that each time a trade occurs, one player is willing to buy at that price and another player is willing to sell an identical number of shares at the same price; there is always a buyer and a seller for every transaction that takes place. Also, it is important to remember that the individual players know their own motivation for buying and selling, but they do not know with whom they are trading or why the other party wants to enter the transaction. The players only see the price and the volume of shares traded.

Thus, we have a series of transactions at different prices and different volumes reflecting the interpretation of different information by the different players. The mutual fund and pension fund are interpreting fundamental information about the company and the value of its stock relative to that information. The specialist is using knowledge of what exists in the way of bids and offers; the hedge fund is watching the tape; and the estate and golf club members are acting without regard to price but on information having to do with practicality in the case of the estate and emotion in the case of the golf club members. As long as the players on both sides of the transaction are fairly balanced, the price of the stock will oscillate in a relatively small zone, as it has in our example. If one of the factions (buyers or sellers) overwhelms the other, the price will adjust accordingly. The reasons for the adjustment in price are unimportant. What is important to the trader or investor is that the price moves in such a manner that its direction can be determined or confirmed from past experience. This is why technical analysts study price behavior. It discounts all known information and interpretation and considers only what the price action implies about future price action.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.