What Sets the Price of Stocks?

Exactly how did GameStop stock increase from $147 to $310 in one day?

Like any other financial asset, the price of any publicly traded stock is solely set by the supply and demand for that stock, at a public stock exchange, at that moment in time. Period. But given the recent price volatility of stocks, perhaps this is good time to take a deep dive to understand exactly how markets establish prices for traded financial assets.

As bitcoin is a financial asset, consider the Poloniex bitcoin exchange, which can be found at:

Clicking on the “Depth Chart” tab brings up something like this:

The upper left red section represents the “supply” of bitcoin for this exchange, the amount of bitcoin and the associated price that entities have indicated they are willing to sell at. The lower left greenish section represents the “demand”, the amount of bitcoin and the associated price that entities have indicated they are willing to buy at. One should expect that the sellers try to secure a high price, with buyers attempting to secure a low price.

The exchange’s job is to find a convergence, where a listed buy and sell price are equal, allowing for bitcoins to be exchanged.

There is a subtle point here. If everyone just placed what is known as a “market order”, which means to buy or sell at the established price, there would be no established price! To establish a price, “limit orders” must be placed, which is what you see in the left column. Meaning that it is the balance between the limits orders that allows the market to find the convergence, to establish the price range, which in turn allows for market orders to execute.

After all, who would place a market order if they did not have some idea as to what the price range was?

Consider the following simple example. Five entities have placed limit orders to buy various amounts of shares of ACME stock at $4, $5, $6, $7 and $8 dollars. Five other entities have placed limit orders to sell shares of ACME stock at $10, $11, $12, $13 and $14 dollars.

One way of graphically representing this data is follows, where the horizontal axis is the price per share, and the vertical axis is the total amount of the limit order.

An alternative view would be to accumulate the order amounts in both directions away from the center. This gives a better idea of the “depth” of the market, for both the sell and buy limit orders. This is how the Poloniex bitcoin exchange represents the data. If the depth becomes lopsided in one direction of another, then it can be expected the price will eventually adjust to balance the weight of both sides.

Given these limit orders, what should the price be?

Remember that a price needs to be established to allow for market orders. And unless market orders are placed, in this example no stock will be exchanged as there is a two dollar gap between the lowest limit sell order and the highest limit buy order.

But we do know that the price range is $8-$10, at least for small orders.

Assume that someone places a small “buy market order” for one share of ACME stock. This would get paired with the lowest “sell limit order”, which in this case is $10. The result being that there would be just 4 shares left to sell at $10.

Aha! We now have an established price, and it is $10 per share.

Someone next places a “sell market order”, which would get paired with the highest “buy limit order”, which would be $8, which would now in turn be the next established price.

Yes, a little price volatility.

Next consider the case where demand greatly exceed supply, because someone places a “buy market order” for 13 shares. This order first gets paired with the 4 shares at $10, followed by a pairing with the 4 shares at $11, followed by the 3 shares at $12, and finally 2 of the shares at $13.

The price per share just jumped from $8 to $13, with this relatively large order resulting in significant price volatility. Which is what happens when large buy market orders overwhelm the supply, namely the available sell limit orders.

Which explains how a stock can double in one day.

One can start to see the problem if the exchange consists of just a handful of entities buying and selling. It stands to reason that the more limit orders there are, both buyers and sellers, the better. That a market needs to be both liquid (allows for many trades with minimal delay) and deep (can absorb large orders). In both cases with minimum short term price volatility.

It cannot be overstated enough that accurate market prices are essential for an efficient economy, and it would be for the betterment of all if all markets were as transparent as the Poloniex bitcoin exchange is.

It should also be noted that when the large buy market order was placed, removing a swath of sell limit orders, the next round of placed sell limit orders tend to chase the last transaction price, filling in the void. This is human nature, believing that the established price represents something akin to truth, something more than simply what the last transaction was.

Back to bitcoin for a minute…

Poloniex is just one of many bitcoin exchanges. Is it possible that the price the Poloniex exchange establishes for bitcoin, or more technically, the exchange rate between bitcoin and dollars, will be different from the Coinbase exchange price? Absolutely. In fact, there is little chance that they will be exactly the same as the prices are being established by different sets of limit orders.

But the difference will be small, and in the long term will average to something very small as no doubt there are automatic arbitrage bots in operation that automatically scan the bitcoin prices of the difference exchanges, and if there is a significant difference, will profit by buying bitcoin on one exchange and then selling on another.

Want to learn more?

Eric Johnson is a husband, father, engineer, pilot, surfer, investor and amateur astronomer who has read a lot of books on economics.