7, July 2015

It’s easy to imagine share prices being moved up and down by an invisible force which we are trying to figure out. But price movements are all created by traders. And, in fact, it’s not the traders who are quite happy to trade at or close to the last traded price that causes those price movements.

 

A share price can only move if a trader decides to pay a higher price for a share or sell a share at a lower price. And there are numerous overlooked factors that cause traders to move prices. Let’s have a look at some of these factors which don’t even make it into the news.

 

A share price rises when a buyer decides to pay a higher price, than the last traded price. Likewise, a price will fall when a seller decides to sell at the bid price lower down, rather than offer their shares at a better price. It’s not necessarily “more buyers than sellers” that causes a price to rise, but “more aggressive buyers than sellers.”

 

So who might become a “price taker” rather than a “price maker”?

Buyers:
If I want to own a share, I will probably sit on the bid. If I need to own a share, I’ll probably take the offer. So why might traders need to pay higher prices?

• Weak shorts: The most aggressive buyers are usually traders with short positions in a rising market. When you have a short position, your potential loss is theoretically unlimited. Equity markets also have a natural bias toward higher prices, so it’s entirely possible with a short position that the share will never trade at your entry level again. Traders with short positions in rising markets can, therefore, become very aggressive buyers. This becomes magnified if those positions are leveraged, and they literally cannot afford to maintain the position. This is what is known as a short squeeze.

• Funds underweight equities: Fund managers usually have a minimum equity weighting they have to maintain. They also have little control over the money flowing into or out of the funds they manage. They may be hoping to buy shares at lower prices while their funds are simultaneously receiving inflows. Eventually, they end up in a position where they are holding too much cash and not enough equities. At some point, they have to start buying. This buying can trigger other fund managers in a similar position to also start buying. So although the fund manager didn’t want to pay the higher prices, eventually they were forced to.

• Momentum investors and trend followers: Momentum investors buy assets whether they are shares or indices when they are moving, the rationale being that they hold the asset as long as it keeps moving. Trend following funds use systematic rules to buy assets when certain levels are breached ‒ sometimes a previous high and sometimes a moving average. Both of these types of investors are following a process that entails buying strong assets with rising prices, with little discretion involved.

• FOMO (Fear of missing out) investors: Almost all fund managers, professional traders, and retail investors have bought a share at some point for fear of missing out on profits that other people are making. This is, of course, to fulfill a psychological need.

Sellers:
So what about the sellers who need to get out of a position? What type of trader will hit the bid rather than offer their stock with the other sellers?

• Short-term traders being stopped out: Short-term traders will often use leverage, and they will use stop losses to limit their losses on losing positions. This is responsible trading. However, it does mean that if a price falls below their stop loss level, they need to get out of their position. They may not want to sell at that price but if they are following a proper risk management process they need to. This effect is also magnified when one trader is stopped out, hits the bid and triggers the next trader’s stop-loss.

• Writers of put options: If you buy a put option on a share, the seller will usually hedge that position dynamically. That means that as the price of the share falls, they will sell shares until eventually, they are 100% hedged. They don’t sell at the price they want to sell, but at a price they need to sell.

• Fund managers with outflows: If a fund manager’s clients withdraw funds, that manager may have to sell shares to fund the withdrawal. While they may want to sell shares at a higher price, they may be forced to take the prices they can get.

• Investors taking pain/capitulating: If an index, or even just a single share falls a long way, often investors have to cut their losses to stop the pain. This is the reverse of FOMO and is sometimes referred to as capitulation. This also often takes place collectively at market bottoms, where investors all decide together that they want out. If it turns out that they were, in fact, the last ‘weak’ holders, then that does create the bottom, but that’s a topic for another post.

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So these are some of the market participants who will move a price because they need to. But what about valuations, fundamentals, sentiment and news flow? Well, it’s not often that one needs to trade based on these factors. That’s not to say that an investor won’t make a rational decision to pay up to build a position in a share. Investors do make rational choices to move prices based on changing fundamentals, news flow, and valuation analysis.

 

So, what's the point of knowing all of this?

The point is that prices may well move more often because market participants are forced to act, rather than because they make rational decisions. Many price moving trades are made because of factors beyond the trader’s control.

 

Thinking about what may cause a share price to move can help an investor to understand whether they are acting in their own self-interest when entering positions. This also applies to developing a process – is your process proactive or reactive?