September 8, 2011 | In: General

Who Sets the Price of Stocks?

Many beginners in the stock market, as well as would be part-time stock traders, want to know who sets the price of stocks. They think that there’s an entity/organization who is responsible of setting the price of a stock. Now while stocks in the US are regulated by the SEC (Securities and Exchange Commission), the price of each individual stock is set by the investors. In short, the price of a stock is set by the price that one is willing to sell at, and another is willing to buy at. In shorter, the price of a stock is set by supply and demand. Here’s how:

Let’s say someone (Investor Y) wants to buy 10,000 shares of NFLX at the current price is $216. This means that there are some investors, owning Netlfix shares, who are willing to sell at that price. Here’s a breakdown of those investors (I’m only giving an example):

- Investor A: Owns 500 shares willing to sell at $216
- Investor B: Owns 1,000 shares willing to sell at $216
- Investor C: Owns 5,00 shares, also willing to sell at $216

When Investor Y executes the trade, his order will be immediately filled with 2,000 shares at $216. Now he still needs 8,000 shares for the order to be completely filled. There are some traders who are willing to sell, but a slightly higher price:

- Investor D: Owns 4,000 shares willing to sell at $217
- Investor E: Owns 4,000 shares willing to sell at $218

So, the order will then be automatically filled with shares that have the closest price to the previous trade, which are the above shares. The order now is filled with 10,000 shares: 2,000 at the price of $216, 4,000 shares at the price of $217, and 4,000 shares at the price of $218. The average fill price for the investor would be: $217.2 (I will discuss the average fill price in a later article).

At the end of the transaction, the price of the stock will be $218, up $2.

Now let’s look at this from the opposite perspective. Let’s say that Investor Y wants to sell 10,000 shares of NFLX, at the current price of $216. When the order is executed, the system will find the following:

- Investor I: willing to buy 4,000 shares at $216
- Investor J: willing to buy 2,000 shares at $215
- Investor K: willing to buy 4,000 shares at $212 (notice the drop of $3 from the above price)

The order will be filled with 4,000 shares at $216, 2,000 shares at $215, and another 4,000 shares at $212. The total sale will be for $2,142,000 and the average fill price will be $214.20. After the order is completely filled, NFLX will drop $4 to $212.

Now what will happen if nobody wants to sell or buy? Usually this situation doesn’t happen with stocks that have high liquidity, but it does happen with stocks that are not very liquid, especially when the number of shares requested (to sell or to buy) in one single order is relatively very large (when taking the average daily volume into consideration). In this situation, the stock price will keep going up (if it’s a buy transaction) or down (if it’s a sell transaction) until it finds someone who’s willing to sell or to buy. This is why so called small cap stocks are very volatile when compared to large cap (or blue chip) stocks.

Note that the buying/selling/filling process is completely automated in this day and age, and hence, you can say that the price of a stock is determined by a computer!

This article (as well as all other articles on this website) is an intellectual property and copyright of Fadi El-Eter and can only appear on fadi.el-eter.com.

2 Responses to Who Sets the Price of Stocks?

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What Is the Average Fill Price? « Fadi El-Eter

September 8th, 2011 at 7:24 am

[...] my previous article clarifying how stocks prices are set, I have mentioned the term average fill price. So, what is the average fill price and how it is [...]

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Where Can You Buy Stocks? « Fadi El-Eter

October 18th, 2011 at 7:58 am

[...] that I always get from new investors is: “OK, now I know how the stock market works, how stocks prices are set, and I want to join the game! But, I still don’t know where I can buy [...]

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