Price Discovery ☑️ Explained for Dummies

What is price discovery?

Price discovery is a process during which the fair market price of an asset, security, commodity, product, or service is determined through the interaction between sellers and buyers, based on market supply and demand. WallStreetMojo indicates that this process ‘helps one identify whether a tradable asset, such as a financial security, currency, or commodity is currently oversold or overbought.’ Price discovery is the central function in any marketplace, including online marketplaces.

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How does the process of price discovery work?

The process of price discovery begins with general market prices, followed by interactions between buyers and sellers and ends with a transaction price (also referred to as the spot price or fair market price) of an asset or a given quantity of a product - based on demand and supply - at a specific time and place. WallStreetMojo explains that the price discovery process ‘involves finding the price at which demand and supply curves intersect, thus allowing the transaction to occur.’

Factors influencing the price discovery process

The price discovery process in the markets is influenced by various factors, including the following four factors:

Information

Buyers, sellers, and investors have information available on a daily basis. Financial news outlets report and explain what events caused markets to fluctuate. These reports include announcements and decisions by central banks (like the South African Reserve Bank (SARB) and the Federal Reserve in the USA), global economic indicators, economic factors in a country, as well as political events. Information about companies can be obtained from financial reports, financial statements, and announcements by boards of directors. The information enables sellers and buyers to set the price levels they want to sell or buy.

Liquidity

Market makers, also known as high-volume traders, play a crucial role in the liquidity of markets. They ‘make the market’ by being ready to constantly buy and sell assets (securities) at the bid/ask prices published on exchanges. Typically, the spread - the difference between the bid/ask prices of the market maker - is nominal. However, when markets are considerably volatile, or there is not a ready market for a particular asset (security), the spread will get wider. Hence, the price discovery process to discover the fair market price of the asset (security) may take longer.

Price determination

Price determination refers to the interaction between the market forces of supply and demand that creates the market price levels. For example, in bull markets, a flourishing economy and positive investor sentiment positively affect prices, pushing them higher. Contrarily, in a bear market, negative investor sentiment and slow economic growth negatively impact market prices, driving them lower. The balance of sellers and buyers in the market has the most significant effect on price. If buyers are aggressive in their bidding, sellers will continue to raise the price. Similarly, if buyers have a less aggressive approach, sellers will continue to reduce the price. The levels of support and resistance in the market reflect the market forces of demand and supply. The support level indicates the lowest price point until the buyers are prepared to buy more of the asset (security), driving the price higher. Contrarily, the resistance level reflects the highest price at which buyers become reluctant to purchase, compelling sellers to lower the price.

Risk perceptions

The risk appetite of a seller or buyer can have a considerable effect on the level at which market participants agree on a fair market price. For instance, if a buyer accepts the risk of a decrease in price in exchange for the possibility of a reward of a significant price increase, he/she may be inclined to pay a little more in order to protect his/her market exposure. This is an indication that the asset’s price is set higher than its inherent value would signify. Investors/traders overbought the asset in this case, while it is anticipated that the price will drop in the coming days or weeks. As a risk-to-reward ratio, price discovery can be used to evaluate risk, helping buyers and sellers control their risks by placing stops and limits on financial assets in their investment portfolios. Other factors affecting price discovery are:

The number of buyers and sellers
The psychology of sellers and buyers
Emotions of buyers and sellers
Volatility
Production costs of the items sold
Quantity of the items for sale
Recent purchase prices
The economic scenario
The political situation

Example of price discovery

Exchanges, such as stock exchanges, are considered auction markets where financial instruments like shares, commodities, bonds, and derivatives are priced and where buyers and sellers contest bids simultaneously. On exchanges, prices for listed shares, bonds, or commodities are regularly updated throughout the trading day. For instance, if a trader/investor intends to buy or sell a number of shares of a specific company, the exchange quote also called the stock market quote or stock quote, will provide essential information about the shares. Information like the bid/ask, which displays the current share price. The bid is the highest price at which buyers are willing to pay, while the asking price indicates the lowest price at which sellers are willing to accept. The stock quote reflects much more than the current share price. It includes other valuable information like trading volume, yield, and the price and number of shares bought in the most recent transaction. The price discovery process can be summarised as follows:

As supply increases, demand is falling, normally indicating that the value of the shares will decrease.
When the two lines - representing supply and demand - on a graph cross, it signals a level that both buyers and sellers consider it a fair market price for the shares.
Consequently, the shares will start to trade at this level until the levels of supply and demand move, requiring another phase of price discovery.

Price discovery versus valuation

Price discovery is not similar to valuation. Contrary to price discovery, which is a market-driven process, valuation is a model-driven method. Valuation is the present value of factors such as assumed cash flows, competitive analyses, interest rates, current and expected technology advancements, as well as various other factors. Valuation is also referred to as intrinsic value or fair value. Some analysts are able to evaluate if an asset is over-priced or under-priced in the market by comparing market value to valuation. Obviously, the market price is the correct price. However, any variations in the market price may affect trading opportunities if and when the market price transforms to include any information in the valuation models not previously considered.

Importance of price discovery

The price discovery process is an important tool in trading because supply and demand are the driving forces in financial markets. In markets always in a continuous upward (bullish) and downward (bearish) change, it is crucial to regularly re-evaluate whether a financial instrument, commodity, or currency is currently overbought or oversold. Furthermore, it is essential for buyers and sellers to assess whether the current market price of an asset is a fair price. Assessing whether a financial instrument or any other asset is trading lower or higher than the market value, enables a trader/investor to determine whether opening a short or long position, is an informed and wise decision. The price discovery process on financial markets (exchanges) is necessary to provide all investors/traders with the same information simultaneously, maintaining fair, structured, and efficient markets. Bear in mind, that while price discovery on the markets supports and advances fair prices, it does not necessarily indicate the true value of a particular financial instrument, commodity, or currency. Noteworthy, in the USA, the U.S. Securities and Exchange Commission (SEC) regulates the exchanges to protect individual investors. Regarding stock exchanges in South Africa, the ‘JSE acts as the frontline regulator, setting listings requirements and enforcing trading rules, while the financial sector conduct authority (FSCA), supervises the JSE in the commission of its regulatory duties,’ according to the JSE website. (Accentuations by the article writer.) Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional and regulated commodity broker before making trading and investment decisions.

Price Discovery Explained for Dummies