Category: Trading 101

Even though this video is very old, it is an amazing “investment” of your time to watch it. It’s an old cartoon of how the New York Stock Exchange works.

Most people know of a co-worker, a friend or even a family member who is actively involved in the stock market – maybe that person “made a killing” or “lost their shirt”. The greatest feature of the stock market is also its greatest hazard: namely that anyone with capital can participate. One of the biggest advantages that great traders have over beginners is that great traders understand that a market is actually an arena of opinions and beliefs.

In this article, we want to expand upon the idea of markets as competitive arenas. Specifically we want to show you that when thinking about trading, it is very important to understand that price is just a reflection of beliefs about a particular stock.

Pick a price, any price

In one of our previous articles, we described the market as a “price discovery mechanism” – that is, through the actions of buyers and sellers of a good (in this case a stock), the market price of that good can be established. In the highly complex world that we now find ourselves in, money – or more accurately purchasing power, is critical to keeping the world going. Having a mechanism to ensure we know how much ‘things’ are worth is absolutely essential to allow people to exchange the right amount of money for those things.

When you see a price quoted for a stock, it is actually slightly misleading in the sense that it leads you to believe that a stock has only one price, when in fact the price for a stock could be one of three prices.  In stock trading language, the price a buyer wants to buy at is known as the “bid price”; the price a seller wants to sell at is known as the “ask price” and the price they ultimately settle on is known as the “last price”.  It is the “last price” that is often quoted as the “market price”.

What makes a market?

If there’s one thing that you can guarantee about the stock market, it’s that everyone has an opinion. At first blush, it seems fairly obvious that with so many different people participating in the market, there’s bound to be differences of opinion.

What many observers and inexperienced investors/traders don’t do, however, is to look deeper at what it is they’re actually saying by admitting that there are so many different opinions. By acknowledging the differences of opinion in the market, the most profound insight is that not everyone can be right at the same time. In other words, somebody has to be right and somebody has to be wrong. It is this very disagreement, in fact, that makes a market.

Two’s company but three’s a market?

So why is this seemingly trivial piece of information actually incredibly valuable? To understand why, we have to take a step back and understand first where a “market” comes from.

Simply put, a market arises because a buyer wants to buy something and a seller wants to sell something. Where they have to come to some agreement on is price. It is for that reason that markets are sometimes referred to as “price discovery mechanisms”.  One of the favourite questions Sparx encourages beginner traders to ask is: “how much is something worth?” Think about that for just a moment. The answer is “whatever someone is willing to pay for it”. Without both a buyer AND a seller, there is NO market.

Markets are born out of disagreement; they are built on one party believing one thing and another believing the exact opposite. For this reason, buyers and sellers compete directly with one another in what some call a “zero-sum” game meaning that the “winner” wins at the expense of the “loser”. While this is mostly true, there are also slews of “middle men” or brokers that facilitate buyers and sellers’ transactions (more on that in another article).