Price discovery is the primary function of exchanges like Nasdaq and the New York Stock Exchange (NYSE). Here’s a look at how the price-discovery process works and what influences buyers and sellers in the financial markets.
Definition and Example of Price Discovery
Price discovery for financial assets, stocks, bonds, commodities, and derivatives takes place on exchanges. Exchanges are auction markets where buyers and sellers simultaneously enter competitive bids. The exchanges publish prices for each listed stock, bond, or commodity that are continuously updated throughout the day. For example, if you are interested in buying or selling 100 shares of the XYZ company, the quote on the exchange will look something like this:
How Price Discovery Works
Price discovery in the financial and other markets is influenced by the following factors.
Price Determination
Price determination refers to how the general forces of supply and demand set market price levels. In bull markets, for example, a healthy economy and positive investor sentiment drive higher prices across the entire market. In bear markets, however, a slow economy and negative investor sentiment tend to depress market prices. The balance of buyers and sellers in the market has the most impact on price. If buyers are more aggressive in their bids, sellers will continue to raise the price. If buyers are less aggressive, sellers will continue to lower the price. This balance between the two forces in a market is reflected in the resistance and support price levels. The support level translates to the lowest price reached until buyers become willing to buy and drive the price up. Conversely, the resistance level equals the highest price at which buyers become unwilling to buy, at which point sellers reduce the price.
Information
Every day, the financial news outlets report what events caused the markets to go up or down. Investors react by buying or selling when they absorb news about Federal Reserve decisions, economic indicators, political events, and more, as well as news about individual companies.
Liquidity
Market makers—high-volume traders that literally “make a market” for securities by always being ready to buy or sell—transact at the bid/ask prices they publish on the exchange. Generally, the difference between the market maker’s bid/ask prices, called the spread, is very small. When markets are volatile, or there is not a ready market for a security, the bid/ask spread will get wider, and the price-discovery process may take longer.
Price Discovery and Book Building
Private companies that decide to offer stock to the public typically hire an investment bank to guide them through the initial public offering (IPO) process. In most IPOs, the investment bank commits to purchasing all of the shares at an agreed-upon price, based on its assessment of what the market will pay for the new shares. During these IPO roadshows, bankers will solicit feedback from the market about the IPO and its pricing. Potential investors submit non-binding bids for the number of shares they want, and the price they are willing to offer. These indications of interest are an important part of price discovery for the offering.
What It Means for Individual Investors
The price discovery process on financial exchanges is intended to give all investors the same information at the same time to maintain fair and orderly markets. The U.S. Securities and Exchange Commission (SEC) regulates the exchanges and other market participants to protect individual investors. It’s important to remember that while price discovery on the exchanges promotes fair prices, it doesn’t necessarily reflect the true value of a particular security.
