What constitutes a price? Actually, there are three types of prices: asks, bids, and settle prices. Logically, all asks should be higher than all bids; other- wise, they would overlap. When they do overlap, asks and bids match at those price levels, and transactions take place, generating new settle prices.
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This applies to the entire price region in which bids and asks coincide, and the exchange quickly returns to a status quo in which all remaining asks are higher than all remaining bids. The fast dynamics of the open outcry—in which dozens of traders interact efficiently—guarantee that an overlap of asks and bids never lasts for more than a couple of seconds.
Both asks and bids are potential(or virtual) prices only. Not until they coincide in a settle price is there a transaction, at which point there is an exchange of cash for the transfer of ownership of the shares. Therefore, what is important is the spread between the ask and the bid that are closest to each other. The asks and bids not within this spread have no direct influence; they remain virtual. This is why a single share traded within the range of the cur- rent spread is very significant, whereas thousands of shares on offer or on demand some distance away from the spread are of no current significance.
Again, price formation is a boundaryphenomenon created between buy orders and sell orders where they stand closest to each other. Everything away from that boundary is unimportant, at least for the time being.
Once a flurry of transactions has exhausted the potential of a new set- tle price, another process begins. Market players try to figure out what has just happened and—based on this analysis—what they should do next. On their screens, they see (among other things) the most recent settle price and the two previous ones. The questions they ask themselves are, “What does this latest development suggest is coming next? What should Ido next?”
In other words, this is a feedback loop: A decision is implemented that changes the playing field to some extent, and this leads to analysis and a new round of decision making and action. Each new settle price signals the end of an individual “game” played by two traders who have entered an ask and a bid since a settle price was last generated. At the same time, each set- tle price sets the level from which new (or the same) traders can start new individual “games.”
Alternatively, the market for an individual stock may go dormant. The fact that a market may become dormant for an indefinite period each time a settle price has been set underscores that fact that prices have no inherent momentum and no internal dynamics. It is the prospect of future profits or losses that relaunches the play (or fails to relaunch the play) on the exchange. This also demonstrates the major difference between the motion of a body in space—like the bullet or the interplanetary probe mentioned before—and the motion of a stock. The trajectory of a stock is defined by a series of consecutive “games,” separate but linked, each involving only two traders. These individual “games” cannot be considered entirely inde-
pendently of each other because each grows out of the previous game, and yet each game is closed unto itself. Unfortunately for economists, there aren’t any great parallels in the natural world.
With this background under our belts, we can see more clearly why some traditional interpretations of stock price formation do not work. Sup- ply and demand, for example, presupposes a static view of price formation that does not reflect the volume and rapidity of the feedback that takes place in the context of an open outcry. Supply and demand are implied in the existing standing orders, of course, but such orders do not determine price directly. As we have seen, prices are determined on a boundary, where a particular ask level and a particular bid—those closest to each other—are facing each other across a spread.
Supply and demand collapse two elements of a different nature: first, the volumes associated with the closest ask and bid that will materialize into a settle price when a trader makes them meet and, second, the “pull”
created in one direction or the other when standing orders on both sides of the market get activated when new settle prices reach them. Again, this is a contingent, dynamic universe—not at all like the static world of the supply- and-demand model.
Also undermining a supply-and-demand explanation is the fact that the quantities of shares associated with particular asks and bids may very well be small. Hence, under certain circumstances, it is relatively easy to move the market one way or the otherand thereby to define the location where the next price “game” will occur. Monroe Trout, of Trout Trading Company, explains (in an interview in an interesting book called The New Market Wiz- ards) how he moves the market while trading very small volumes.You can safely ignore the technical details, but try to follow Trout’s tactics:
For example, if I’m long one thousand S&P contracts and it’s 11:30 Chicago time, I’m probably going to want to put in some sort of scale- down buy orders, like buying ten lots every tick down, to hold the market in my direction. It doesn’t cost me that many contracts at that time of day to support the market, because there are not a lot of contracts trading.”3 What’s going on here? Trout is holding the market with small lots of 10 con- tracts at lunchtime, which is a time of day when trading tails off signifi- cantly. No, such small pushes are unlikely to have a lasting influence, especially if subsequent heavy trading swamps them. Still, in a thin trading context, they may very well end up bending the market in the hoped-for direction. Remember: What makes this possible is that every change in price
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is regarded as significant by the actors in the drama, no matter what the volume that is associated with that particular settle price.
We also can see more clearly why the notion of equilibriumcomes up short in the real world. Equilibrium theory assumes that there is a natural disposition for a stock price to return to its meanor average value—there- fore, mean reversion. However, the stock market is not mean-reverting because stocks do not havean average price. Think about the logic here: If stock prices were mean-reverting, investors whose interest is in capital gains would have noticed this unhappy reality a long time ago and would never buy stock for the long run.
Of course, the case is very different with interest rates, which tend to move within a range of, say, 1 and 15 percent. If you are looking at either of those extremes, it is a safe bet that interest rates eventually will revert to their mean. Stocks, however, simply do not work this way.