Tuesday, May 27, 2008

Stock Markets - 3

There are a variety of prices at which transactions have occurred. The last sale is the most recent transaction that has been recorded into the system. There is also the high and the low, typically reached earlier in the day. The last should be somewhere between these two. Also included is the previous day's closing price. Yesterday's close can stand in any relation to today's high and low. Also included are best bid (the highest limit offer from buyers) and best ask (the lowest limit offer from sellers). These should sandwich the last transaction price with the best bid lower than the best ask. These limit orders have not yet been executed. And there should be a little graph of price versus time of day. Note that there are fluctuations in the graph. It is not a horizontal line.

If the market is always in equilibrium and yet the price changes over the course of the day this means the equilibrium must change, which in turn means that either supply or demand also must change over the course of the day. Before asking why this is the case, let's simply summarize that point. The statement that the market is in equilibrium and that disequilibrium trade does not occur has nothing to do with whether prices vary over time. Disequilibrium trading means that at the prevailing price either some buyers can't buy or some buyers can't sell (or that there is involuntary accumulation or reduction of stocks so that trade is accommodated). Equilibrium pricing means that at the prevailing price all agents that want to can (and therefore do) trade.

There is an issue whether disequilibrium is created over night when the market closes and if it persists into the opening the next morning. Actually, the current global system is close to but not exactly like a single never closing market.

SEC Study on ECNs and After Hours Trading

If the future could be predicted perfectly asset prices wouldn't vary much and then would change only as fundamentals changed. Of course, we can't predict the future. Instead, we guess at it. We form expectations of what might happen and those expectations are usually an amalgam of various scenarios, each possible and each of which excludes the other. As we gather information our views change. We rethink the likelihood of certain future events in the wake of the news and change our expectations as a consequence. Thus, it is the arrival of "news" and the processing of new information that drives the changes in supply and demand in the stock markets.

One of the "fun" ways to see how news affects asset values is by considering sports polls. If a highly rated team in the polls loses, its rating (which is like an asset price) likely will fall. If a less highly rated team has convincing wins over a rated team, the less highly rated team will rise in the ratings. Why is that?

College Football Poll
College Basketball Poll

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