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Market Edge Report: Price – Part I

Market Edge Reports empower the self-directed investor. Each report investigates a single market metric in depth. We don't just give you numbers, we show you where to find them yourself, suggest what you might want to watch for, and offer some perspective as to what it all means.

Price and Value
Warren Buffet once said “Price is what you pay, value is what you get.”

That's a simple point, but in truth, price and value are overlapping concepts. If you are interested in knowing the “should be” price for a stock, you can find my beginner's guide to fundamental analysis here. Today's Market Edge Report is not about what any stock's price should be, but about what stock prices actually are. Everyone knows that price is determined by the free market, but I find most people have little idea how. I'm going to try to remedy that today. Knowing the how won't point you in the direction of the next homerun stock; what it will do is give you the subtle yet certain advantage that comes with depth of understanding.

To begin with, even the poorest stock has not one but three prices at any given time: its last price, its bid price, and its ask price. When you see a price displayed on a screen (or scrolling by on one of those virtual ticker-tapes) what you are seeing is what the stock's price was at the time of the last trade, not what its price is at present. More often than not, it isn’t the price you'll get, even if you send in the very next order.

If you put in a market order to buy a stock, you pay the ask price. If you put in a market order to sell a stock, you receive the bid price. Ask prices are higher than bid prices, so if you buy and sell the same stock simultaneously, nothing will happen except that you will lose a little money (in addition to whatever commissions and transaction charges you're paying.) This difference is the notorious spread. The spread is the market's little share of every trade that is made. Without the spread, the market as we know it simply wouldn't function. Fortunately, on heavily traded stocks, spreads tend to be very small – mere pennies, in fact – but pennies add up, and that leads us to…

Market Makers

Market makers comprise the big investment banks that spring up to grab their share of the market's lost pennies. For the moment, imagine that there are only five such companies: Alistair, Baker, Cooke, Dmitri and Evens (and that they prefer to be referred to by the first letters of their names only). For each important stock, our market makers have analysts working furiously to determine the stock's value. That's important, because market makers must always (at least while the market is open) be able to answer two questions: how much would I pay right now to buy this stock, and how much would I take, right now, to sell this stock.

The stock of the day is ZZZ. What is it worth? Here is what our market makers think, based on what their analysts are telling them: A $47, B $39, C $32, D $49, E $52.

Note that A, D and E see a more valuable ZZZ than B and C. For this reason, A, D and E have accumulated a large number of ZZZ shares, while B holds only a few, and C has none at all. Before we go on, let's also throw in a couple of wild cards. First, E has had an excellent quarter, and with only a few days of trading left, the company wants to lock in its winnings, so it isn't all that eager to trade anything. Second, D is currently cash poor, making the company a motivated seller but a reluctant buyer.

Julian Close

Julian Close became a stockbroker in 1995. In his 20 years of market experience, he has seen all market conditions and written about every aspect of investing. Julian has also written extensively on corporate best practices and even written reports for the United Nations. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.