Contrary to popular belief by the majority of the general population and even investors and traders stocks are not tied to their fundamental values or even the companies that sold the shares to raise capital. Stock prices are tied to simply what the current buyer and seller in the market is willing to exchange ownership for. That is what determines price, nothing else. So the big question is what are the rules that govern the change in a stocks price?
The laws of economics governs price movement in the market. There are three laws articulated by legendary trader and market pioneer Richard Wyckoff that captures what causes current price reality and what changes it.
The Law of Supply and Demand
The excess of demand (buyers) over supply (sellers) causes a stock’s price to go up. The excess of supply over demand causes a stock’s price to go down. But sellers and buyers are always equal, there are never more buyers than sellers, prices move until they are where the current buyer is willing to buy from the current seller at the market.
The price is determined by the law of supply and demand.
The price moves up and down to balance the supply and demand to the equilibrium.
“The stock is only worth what other people are willing to pay for it” That is the true fundamental value, the current quoted market price not the P/E, book value, or what a trader thinks it is worth.
Law of Cause and Effect
The balance of supply and demand can be shifted by a cause.
The cause could be a good fundamental news, or good news from the same sector, or strong overall market condition. The beliefs about how this news effects future prices is the true catalyst however.
A perceived positive event will generate excessive demand for the stock, thus a good effect (stock moves up).
The Law of Effort and Result
For a stock price to move (result), how much volume (effort) is associated with the move.
When the result (price) and effort (volume) are in harmony, the trend is likely to continue. However, if they are out of sync, for example, when volume is large, but price moves little, the current trend is in danger, and defensive measures must be taken.
Rick Redmont gives a simple example:
“You are looking at a stock. It trades 10,000 shares and goes up one point on the first day. [You see the effort and result.] The same thing happens on the second day. On the third day, it trades 20,000 shares and goes up 1 point. On the fourth day, it trades 40,000 shares and goes up half a point. On the fifth day, it trades 80,000 shares and is unchanged. [This group forms a cause, the effect of which is demand becomes exhausted.]
“On the third day, you had to exert twice as much effort to get the same result (as the first day),” Redmont noted. “The key to analyzing supply and demand is that the demand side burns itself out.”
“When the buying is through and satisfied-there is always supply there. That’s why prices go down faster-because supply is always there and demand is not. All you have to do is withdraw people who want to buy and prices fall.”