The trader's profession: what is behind the value of stocks?
Igor Dombrovan, Managing Director of Saxo Bank in Russia
Stocks are constantly changing in price, and it is the price dynamics that drive people to trade stocks and CFDs. After all, if stock prices did not fluctuate, trading them would not be profitable.
So what influences price changes in stocks? Why is it possible to buy a stock at one price now, and in a minute at a completely different price? In fact, price dynamics in the stock market is determined by many factors.
The catalyst for a move can be anything from the release of an earnings report to macroeconomic indicators. But at the heart of it all is supply and demand. To succeed, you need to be able to think globally, see the big picture, and not focus on just one or two factors.
To understand why and how the value of a stock changes, you need to know the following:
- How the forces of supply and demand work;
- Who participates in the stock and CFD market;
- What traders pay attention to when valuing a stock.
Supply and demand in the market for shares and CFDs
Stock and CFD prices are driven by the forces of supply and demand. Supply is influenced by the number of stocks and CFDs available for investment. Demand is driven by traders' willingness to buy or sell a particular stock or CFD.
A supply and demand chart is shown below
Where Price is Price, Demand is Demand, Supply is Supply, Quantity is Quantity.
Demand is shown by a line descending from left to right and supply is shown by a line ascending from right to left. The point of intersection of these lines represents the market determined price of a share or CFD.
Supply and demand may vary depending on market conditions. The following factors may affect the price of a stock or CFD:
- Increased Demand;
- Increased supply;
- Reduced demand;
- Supply Decline.
How does an increase in demand affect the price of a stock or contract for difference
An increase in demand for a stock or CFD leads to an increase in the value of that stock or CFD.
The supply and demand graph shows that an increase in demand will cause the demand curve to rise to the right. Along with the demand curve, the intersection point of supply and demand will start to shift upward. This indicates that an increase in demand for a share or CFD leads to an increase in the price of that share or CFD.
In turn, demand for a stock or CFD increases when a company's quarterly or annual earnings according to published reports exceed forecasts. For example, when Apple Inc. (AAPL:xnas) announced that the company's earnings grew rapidly due to strong demand for a new device developed at Apple, the iPod, traders began buying up shares, hoping that the company's profits would continue to grow just as rapidly in the future.
How an increase in supply affects the price of a stock or contract for difference
An increase in the supply of a stock or CFD leads to a decrease in the value of such stock or CFD.
The supply and demand graph shows that an increase in supply will cause the supply curve to move to the right. Along with the supply curve, the intersection point of supply and demand will start to move downward. This indicates that an increase in the supply of a share or CFD leads to a decrease in the price of that share or CFD.
The bid for a stock or CFD increases if the stock is excluded from a major stock index. For example, shares of Honeywell (HON:xnys), a manufacturer of industrial products, used to be part of the Dow Jones Industrial Average index. However, economic conditions changed for the company and it lost significant market share, so Dow Jones decided to remove it from its main index. As a result of this de-listing, many fund managers with investment portfolios based on the Dow Jones Industrial Average index were forced to sell their Honeywell shares, which increased the supply of the company's stock in the market.
How a decrease in demand affects the price of a stock or contract for difference
A decrease in demand for a stock or CFD leads to a decrease in the value of that stock or CFD. The supply and demand chart shows that a decrease in demand will cause the demand curve to shift to the left. Along with the demand curve, the intersection point of supply and demand will start to shift downward. This indicates that a fall in demand for a share or CFD leads to a fall in the price of that share or CFD.
Demand for a stock or CFD may decline when news or rumors unfavorable to the company appear. For example, Merck & Co. (MRK:xnys), an international pharmaceutical manufacturer, was forced to recall its popular arthritis drug Vioxx in 2004 due to information that taking the drug leads to an increased risk of heart attacks. In this situation, traders feared that falling revenues from sales, as well as potential losses associated with legal costs, would negatively affect the profitability of Merck & Co. As a consequence, demand for the company's shares began to fall.
How a lower offer affects the price of a stock or contract for difference
A decrease in the supply of a stock or CFD leads to an increase in the value of that stock or CFD.
The supply and demand graph shows that a decrease in supply will cause the supply curve to move to the left. Along with the supply curve, the intersection point of supply and demand will start to move upward. This indicates that a decrease in the supply of a share or CFD leads to an increase in the price of that share or CFD.
The bid per share or CFD falls when companies buy back their shares. Companies with excess free cash flow that believe their stock price is unduly undervalued often buy back their own shares to increase their value and invest in the company.
Now that it is clear how a change in supply and demand can affect the price of a stock or CFD, we need to understand what can trigger such a change in supply or demand. Or, more accurately, who can trigger such a change.
Equity and CFD market participants
There are a large number of companies and individual investors operating in the equity and CFD markets, and each of them influences the dynamics of supply and demand. Despite the fact that these companies and individuals have come together in one market, each of them is unique and different from the others. Each market participant has their own personal goals, their own conditions that need to be considered in the trading process. Someone wants to enter the market faster and leave it just as quickly, someone is oriented to buy a share or CFD and hold it for a long time. Some market participants have large sums of money on hand that they need to invest profitably, while others manage a small private account. By recognizing the needs and goals of different market participants, you can better understand what is happening in the market and use price dynamics to your advantage.
Let's divide the major market participants into two large groups:
- Institutional Investors;
- Private investors.
Institutional investors - These are large professional market participants, usually managing significant sums of money. They include mutual funds, hedge funds, pension funds and others. Given the scale and degree of influence of this group, special attention should be paid to it when determining future supply and demand dynamics.
Private investors - These are people who make their living by trading stocks or CFDs, or who use trading as an additional source of income. This group should not play a key role in the analysis.
Institutional investors rule the market. Having large sums at their disposal, they can provoke a corresponding change in the value of shares by their decisions to buy or sell them. It is not difficult to guess that a trader who wants to buy, say, 1 million shares will affect the price more than a trader who needs only 100 shares.
Most institutional investors operate with clear guidelines to follow certain trading rules and invest in certain asset classes. For example, some funds are known as large-cap funds. This means they can only buy stocks of companies with a market capitalization of at least $5 billion. Another example is technology funds. They only buy stocks of companies in the technology sector, such as Microsoft (MSFT:xnas) or Google (GOOG:xnas).
By knowing how institutional traders behave, it is possible to determine how the supply and demand balance will change and how these changes will affect price dynamics.
Factors that affect share price
Many factors affect the value of a stock. Some are more important in determining value, while others are less important. Below are four factors that should be given special attention:
- Earnings and other fundamentals;
- Dividends;
- Economic Publications;
- A general shift in market dynamics / sector sentiment.
Earnings and other fundamentals
A company's performance is the main driver for a stock's value. When you buy a share, you are buying a stake in the company, which gives you the right to participate in its successes and failures. Therefore, if a company performs well, many traders want to buy its stock. The demand for the share grows, and with it the price rises. If the company's results leave much to be desired, fewer and fewer traders are willing to buy its shares. Demand for them falls, dragging the price down with it.
To determine a company's performance, traders and analysts look at various fundamentals (i.e., metrics derived from a company's balance sheet and income statement). A company's profits are the amount of money earned by the company after all expenses are paid. This is usually the most important fundamental indicator for traders. But there are other important data, such as return on equity (ROE) and the ratio of a stock's market price to its book value (P/B ratio), that help traders assess the overall health of a company.
Dividends
After earning money, companies can dispose of it in two ways: keep it and invest it in further development, or pay it out to shareholders in the form of dividends. Dividends are sums of money paid to shareholders according to the number of shares they own. For example, if a company pays out 5 million F.S.F. per 1 million shares, each shareholder will receive 5 F.S.F. per share.
Traders pay a lot of attention to dividends because they know they will receive regular payments on their investments. Given that dividends are valued so highly, companies tend to increase the value of their stock by raising dividend payments (if earnings allow, of course). Stocks of companies that increase dividends enjoy a rising price, while stocks of companies that cut dividends become cheaper. Unfortunately, fewer and fewer companies are now paying dividends, preferring to leave money in the company as retained earnings for later investment.
Economic publications
Economic publications are data published by the government and other organizations that affect the economy as a whole rather than individual companies. These include the announcement of a rate decision and the publication of gross domestic product (GDP).
Most economic news that is important to you as an equity and CFD trader is planned many months in advance. For example, the dates of the Federal Open Market Committee (FOMC) meetings where rate decisions are made are known a year in advance. Similarly, the British government plans the dates of the budget and mini-budget publications in advance. Therefore, you have time to research the possible contents of the publication and prepare accordingly.
Investment analysts, economists and other market participants are constantly analyzing upcoming economic publications, trying to predict their contents. While no two analysts are likely to have exactly the same forecasts, looking at the various estimates and assumptions can help determine what is expected from an event on average. This average estimate is called a "consensus forecast".
By knowing the consensus forecast, you can use the price movement at the time of the news release to profit because the consensus forecast is already "factored into the prices" of stocks and CFDs. Here's how it works.
Having finished analyzing the upcoming event, investors start opening trades to make the most of the expected currency movement. They don't wait for the publication itself. They want to be ahead of the market. Thus, by the time the data is published, most market participants have already opened positions.
If the published economic data matches the consensus forecast, stock and CFD prices hardly move at all, as most of the big traders have already opened positions and there is no one else to join in to move the market. If, on the other hand, real data comes out above or below the consensus forecast, the price of stocks and CFDs adjusts up or down to reflect the new economic information. At this time, as market participants try to quickly adjust to the new information, there is a brilliant opportunity to capitalize on price momentum.
General change of dynamics in the market / sentiment in the sector
Companies like to think that their performance is the only thing that affects their stock price. However, there are other general market forces that can cause the price to rise or fall no matter what happens in any given company.
There is a folk wisdom that all stock and CFD traders should know: "A rising tide lifts all boats." This means that in a bull market, most stocks will rise because the market and the economy as a whole is on the upswing. On the other hand, in a bear market, the prices of most stocks will fall because the market or the economy as a whole is in a downturn.
Individual sectors of the economy, as well as the market as a whole, can go through periods of decline and recovery. For example, at one point in time, stocks of companies in the health care sector may rise and stocks of companies in the retail sector may fall. Bullish and bearish forces acting on individual sectors affect stock prices in the same way as overall market forces.