Learn The Stock Market Lesson – The Mind of the Stock Market : Why Do Stock Prices Go Up?

The Fact:

Like many traders, I myself, once believed that prices go up when there are more buyers than sellers and down when there are more sellers than buyers. However, Dr. Alexander Elder stated in his book, “Trading For A Living,” that, although, the previous statement seems logical, it is not true. This is because the number of instruments, such as stocks or futures, bought and sold in any market is always equal by definition. If you want to buy a share of a stock, someone has to sell it to you. Likewise, if you want to sell short a certain share, someone has to buy it from you. It takes two to transact. Essentially, the number of stocks bought and sold is equal in the stock market just as the number of long and short positions in the futures market is always equal. If there is an odd amount, such as only one buyer or only one seller, there is no trade and therefore, there will be no price movement. Rather, the common logic and argument that people hold refer only to those willing to buy and sell.

So Why Does Price Rise And Fall Then?
Prices rise and fall due to the alterations in the intensity of greed and fear among buyers and sellers. This means that every change in price reflects the battle between the bulls and bears. Price rises when buyers feel confident and do not mind paying a little extra because they are expecting prices to rise even higher. When these optimistic bulls meet the fearful and defensive bears, the market rallies and continues as long as bull are greedy enough to meet sellers’ demands.

The more aggressive their feelings are, the sharper the rally is. For example, if buyers feel just a little stronger than sellers, the market rises slowly. It is the job of technical analysts to determine exactly when the buyers are strong and when they are not.

Similarly, the rally ends when many bulls lose their enthusiasm, causing the price to slide. There is now greed among bears and fear among bulls. That’s when the bears feel optimistic and do not care about selling short at lower prices. Bulls are now the fearful ones and they agree to buy only at a discount. As long as bears feel like winners, they continue to sell at lower prices. The downtrend continues until the bears start feeling cautious and refuse to sell at lower prices.

As you can see, the process is more complex than the view that stocks go up when there are more buyers than sellers and down when there are more sellers than buyers. Rather, it relates more to market “panics” in buying or selling. To conclude, there are never more buyers than sellers or more seller than buyers.

For more information, I recommend you to read Dr. Elder’s “Trading For A Living.” This was the first book that I read when I began my trading career and until this day, it is still one of my favorite books. The book covers a lot about trading psychology, which I mentioned in an earlier post that it is crucial to control your emotions. So if you guys haven’t already, I suggest you go to the nearest library and pick up his book or just go on Amazon and purchase it from there.

Futures are not “direct” securities like stocks or bonds. They are examples of derivatives. Dr. Alexander Elder wrote in his second book, “Come Into My Trading Room,” that nine out of ten traders go bust in their first year. Futures offer traders some of the best rewards, but of course, with high risk to them. Like options, beginners tend to avoid futures because of its risk. Although futures might look dangerous at first, the actual danger lies within the people who trade them. As Elder states, “futures do not kill traders—poor money management kills traders.”

When you buy a stock, you own a part of the company. With futures, you do not own anything, but rather you enter into a contract for a future purchase of merchandise. These contracts deliver a specific quantity of a commodity by a certain date.

What is the difference between a futures contract and an options contract?

A futures contract is binding on both buyer and seller as opposed to options, where the buyer has the right but is not obligated to take delivery.

In futures, if the market goes against you, you have to keep adding money to your margin or get out of your trade at a loss. In order to exit the commitment before the futures contract’s delivery date, the holder of a futures position has to offset his/her position by either selling a long position or buying back a short position. This would close out the futures position and its contract obligations.

Like options, there are two main reasons why investors use futures: to speculate and to hedge (reduce risk).

Keep in mind that the main difference between futures and options is that an option grants the trader the right, not the obligation to fulfill the contract, whereas both traders of a futures contract must fulfill contract by the delivery date.