Understanding what price is and what it represents is one of the most fundamental components that divides investors and traders from gamblers in the stock market.
Gamblers don’t care too much about the meaning behind the price of a stock. They simply buy a stock and hope the price goes up. Often times gablers rely solely on word of mouth or their gut to make decisions.
Investors and traders will look at the price and try to understand the story that it tells. They will use various technique to try and measure the potential for the price to go up or down and then make the decision of whether or not to buy or short.
So, what is price?
The most basic definition of price is the amount of money someone must pay to purchase one share of a particular company.
This definition is accurate however, many would say that it is inadequate to truly describe the price of a stock. It fails to include any explanation for why a particular stock has a given price or why different stocks have different prices.
It is similar to if someone tried to describe a diamond by telling you that its chemical formula is C.
Unless you have seen a diamond before, you would probably still be wondering: what does a diamond look like? And why is a diamond different than graphite which also has a chemical formula of C?
Over the years economists and researchers have worked on expanding the meaning of price. One of the more interesting interpretations comes from the efficient-market hypothesis (EMH). We will look more closely at the EMH in a future post but for now let’s take the reader’s digest version which says a stock’s price is a reflection of all available information.
This is a somewhat satisfying definition for price. It explains that a stock has a particular price due to the information available for it. We can also see that different stocks have different prices because there is different information available for them.
The EMH is not without its critics, however. Warren Buffet being one of the more prominent among them.
Intuitively, we know that new information doesn’t become available on a second by second or even daily basis. This leaves only random noise to explain the intraday price movements. Random noise, however, doesn’t explain the patterns that emerge and form the basis of technical analysis.
There appears to be something missing.
Alexander Elder, M.D., a phycologist and professional trader gives us another way to think about price. He says price is a momentary consensus of value of all market participants.
This explanation gives us something very important that was missing from the EMH definition: people. Market prices are set by people. Once again, we will dig deeper into Dr. Elder’s theory of price in a future post. For now, we can take a glance at the highlights.
At any given moment there are three types of traders. Buyers who think the stock will go up, sellers who think the stock will go down, and undecided traders how haven’t made up their mind.
Any time someone buys from a seller or sells to a buyer, a deal is made and that becomes the latest price. That deal represents a meeting of the minds between the bravest buyer and seller in the crowd and incorporates all available information as well as human phycology.
In addition to providing a practical definition for price, Dr. Elder also introduces us to a new concept: value.
To really understand price we must ask ourselves what is its goal? It isn’t to move up or move down. It isn’t to make some people rich and make other people poor. The goal of price is to accurately represent a stock’s value.
So, what is value?
A stock’s value is the monetary worth of the stock or in other words, the fair price.
Value is easy to define in words however, defining value in dollars is a whole other issue. For starters, there is not one agreed upon method for valuing a stock. Long term investor see value differently than short term traders.
Long term investors buy a stock and hold it for many years. Their goal is to pick a solid company that will give them good, reliable returns every year so that they can defer paying capital gains tax for as long as possible.
To calculate a company’s value, long term investors open its books, look inside and use accounting principles as well as financial ratios to analyze it. They will typically use an equation such as Warren Buffet’s famous owner’s earnings formula which yields a dollar amount that is the value of the company.
Many investors also factor in the quality of a company’s management. Intangibles such as this as well as estimates about future earnings are, in large part, educated guesses. As a result, the long term value of a company is subjective.
Short term traders take a very different approach to value. Since they only plan to hold a stock for a few days or weeks, financial ratios and management don’t play a big role in their valuation.
Instead, short term traders derive a company’s value from its charts. Stock charts are the principle tool for traders. They use historical price data to calculate all sorts of indicators that tell a story about the company in question. Among these indicators, one of the most important is the exponential moving average (EMA).
An EMA is used to smooth out the noise in the price data by averaging all of the prices in the window. The window is simply the number of time steps (e.g. days) that are used to calculate the average price. If you have an EMA with a window of 50 days, it means that you are averaging the closing price of the stock for the last 50 days.
If you use different window lengths, you will get different averages. This is what many short term traders do to find a company’s value. They take two EMAs, such as EMA(50 days) and EMA(25 days), and calculate two average prices. The two average prices create something called the value zone and the idea is that a company’s value lies somewhere between those two numbers.
Using different window sizes for the EMAs will yield different value zones so, just like long term value, short term value is subjective.
The basic strategy of long term investors and short term traders alike is to buy when a stock in undervalued and sell when it is overvalued. However, as we saw in the previous sections, value is partly in the eye of the beholder.
A short term trader might think a stock is expensive and want to sell while a long term investor thinks it is a bargain and wants to buy. If more people want to buy than sell, the price goes up. As the price rises, more people begin to think it is expense and will pull the price back down. This is the never ending game of tug-of-war that happens every day on Wall Street.
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