In the Dugout: Pricing and Methods of Trading Stocks

How is Price Determined

In order to understand how a stocks price is determined, we must first understand a little bit about economics. Think back to your Econ 101 class and bring up any knowledge you had about supply and demand. We all deal with supply and demand everyday. Our whole economic system is set up on this idea. When there is an excess of supply, prices go down as suppliers lower prices to clear out the extra product. When there is a lack of supply, prices go up as suppliers raise prices so they don't run out of product. When dealing with stock prices, the same philosophy holds true. Since there is only a certain amount of shares in a company, if there is an abundance of people wanting to buy it, the price will rise to find equilibrium between supply and demand. Since there has to be a seller and buyer in every transaction, it is actually the enthusiasm for the stock that moves the price up and down.

This theory holds true whether the stock is traded on an exchange like the New York Stock Exchange (NYSE) or on a computerized system like the NASDAQ.

What Methods are Used to Trade Stocks

Since the price of a stock moves up or down based on the enthusiasm for the stock, it is a good idea to have some idea as to why buyers would get enthusiastic. There are two main types of analysis that help traders and investors figure out what stocks will create enthusiasm. They are fundamental and technical analysis.

Fundamental analysis (FA) is the study of a company's financial situation and where the company's earnings and revenues are heading. Over the long-term, what ultimately drives the price of a stock higher is its earnings. Fundamental analysis includes things like price/earnings (PE) ratios, earnings per share (EPS) and revenue growth. Sometimes it can take a long time before a company might be recognized as a value. This is the reason FA is not used extensively in short-term trading. Just because a stock may have strong earnings in two years, doesn't necessarily mean it is going to head higher in the next two weeks. Even so, there are ways to use both fundamental and technical analysis to trade stocks short-term.

Technical analysis (TA) is the study of past price movement to determine where prices might be heading in the future. TA includes things like volume, moving averages and dozens of indicators that have been developed to help predict price movement. The most widely used way to use TA is through the use of charts. Stock charts are a great way to see patterns and past price movement all in one easy to view place. There are many types of chart styles that are used, with advantages to each. These include bar, candlestick, point and figure and line charts. It is beyond this lesson to get into the details of charting, but it is the most important aspect of TA.

There is one another type of analysis that is becoming more and more used in the trading world. It is called sentiment analysis (SA). SA is the study of the psychology of the market. SA looks at things like put/call ratios, bullish/bearish readings, short interest ratios and cover stories. The basic idea behind SA is that the crowd is normally right during a trending market, but wrong at both ends. So sentiment analysis is used in conjunction with technical and sometimes fundamental analysis to help predict turning points in the market and individual stocks.

Though TA is the most widely used type of analysis for short-term traders, using all three types together is normally the best route. Other lessons will take a look at different aspects of all three types of analysis and how they are used to trade stocks.

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