Stock market prices, contrary to the widespread assumption of many, are not related to fundamental models or to the business that has sold shares in order to raise funds. Market prices are actually what the latest sellers and buyers are willing to trade for at the time. Since this is how the price is established, what are the rules behind the change in market prices?
Economic laws control the flow of prices in the market. The legendary trader and market pioneer Richard Wyckoff summarises three principles that capture what creates the existing price and what changes it.
Supply and Demand
The market goes up and down to balance the equilibrium between supply and demand.
The imbalance of buyers over sellers causes the price of a stock to rise. The surplus of sellers over buyers allows the price of a stock to go lower. But sellers and buyers are always equivalent, there are no more buyers than sellers, and prices change until the next buyer is able to purchase from the next seller on the market.
Cause and Effect
The supply and demand equilibrium may be altered by a catalyst.
Good corporate news, or bad news about the industry, or robust macroeconomic conditions may be the catalyst. The reality of how this news influences future prices, however, is the true cause.
Increased demand for the stock will be generated by a presumed positive event, hence a good effect aka. stock moves up.
Inadequate demand for the stock will be generated by a presumed negative event, hence a bad effect aka. stock moves down.
Effort and Result
How much volume (effort) is related to the movement for a stock price to change (result).
The pattern is likely to continue when the output (price) and activity (volume) are in equilibrium. However, if, for example, they are out of step when the volume is high, but the price barely moves, the trend is at risk, and protective steps should be taken.