Price Discovery Explained For Beginners

Price Discovery Explained For Beginners

What is Price Discovery

Price discovery is the process where buyers and sellers determine where a transaction can take place based on supply and demand.

This evaluation process uses the economic concept of supply and demand to find a price where a buyer and a seller agree to trade.

The supply and demand for an asset are based on several factors including the future abundance of an asset in any specific location. Transaction costs, as well as transportation costs and the storage of an asset, can play a pivotal role in determining the price discovery.

The formula to determine price discovery is everchanging and will be different for each asset.

Why It’s Important

Did you ever notice that when a new company stock trades for the first time on an exchange like the NYSE, it can take a while for buyers and sellers to agree on a price?

What generally occurs is that buyers move their bids higher and the seller moves their offers lower until a trade is transacted. This process is called price discovery. Its were buyers and sellers agree to a price to allow a transaction to take place.

The process of setting a price on any asset, whether is a security a commodity, or currency pair is referred to as price discovery.

Traders will evaluate several factors including supply and demand, risk, politics, as well as the economic environment during the price discovery process.

How Does It Take Place

The study of price discovery is a relatively new theory, but the concept has been around for thousands of years.

Every barter for goods or services is part of the price discovery process.

Every street market where a vendor is willing to negotiate participates in price discovery. As you can imagine this will change from transaction to transaction.

The Development of Price Discovery

The bizarre in China and India provided some of the first marketplaces around the globe. The issue for buyers and sellers was that the same product could trade simultaneously in separate locations and experience different prices.

The supply and demand in a specific location could be very different and it could take weeks or months for buyers and sellers to realize that prices were higher or lower at a different location.

For prices to be consistent they rely on traders to close an arbitrage.

The term arbitrage means the simultaneous buying and selling of assets in different markets to take advantage of differing prices.

A location arbitrage means that the price difference allows you to transport the price from one location to another and still make a profit.

Vehicles and the telephone helped close location arbitrages around the globe.

The modern-day marketplace has morphed from an in-person ring of traders to an electronic auction where traders place bids and offer to help in the price discovery process.

The advent of an electronic auction has increased market transparency, but still provides scenarios where trades can simultaneously take place at different prices.

Sophisticated electronic trading programs are constantly scanning all possible electronic trading platforms to take advantage of any price anomalies.

Price Discovery in the Marketplace

Price discovery is the most important function of a marketplace.

Every market participant has a reason to purchase and sell at a specific level.

As markets become transparent, the liquidity that is provided creates a smooth movement in price action. Consistent price movements due to observable price discovery increase confidence in a market.

When price discovery is opaque, investors tend to shy away from trading.  Opaque markets tend to have wide differences between where traders are willing to purchase and sell an asset.

Generally, fewer traders are involved in opaque markets.

While the difference between the bid and offer will narrow to generate a trade in an opaque market, investors understand that exiting a position could take time.

For example, you should be confident that you can exit a position in Apple shares immediately after you purchase them. This would not be the case if you decided to purchase a cabin in the middle of an uninhabited rural area.

One of the downsides of a highly transparent asset is that large quantities can be moved quickly which can generate whipsaw price movements.

When it Concerns Day Traders

Price discovery mainly concerns day traders on days IPOs open up for trading and there is no previous price action to trade off of.

In the first few hours of trading, shares can be very whippy and hard to trade. This is because it’s the first time the shares have traded on the open market which means there are no real levels of support and resistances.

This means shares can be very volatile. Trading with that type of price action can be hard to manage risk which could end up costing you a lot of money.

One way to approach IPO trading, especially for beginners, is to let the morning trading cool off. Let the stock establish levels of support and resistance.

This will give you something to trade off of and provide you with a way to manage risk.

PLTR Stock Chart

In the example above, Palantir Tech (PLTR) opened up for trading on September 30. Prices were going back and forth between $10.20 and $11.40 before settling down and establishing and trading range.

Then you can see that at $10.60 prices started to hold on multiple occasions before breaking down and trading lower for the rest of the day.

This is what you want to wait for, especially on IPOs.  Allow prices to establish some sort of price discovery to trade from and then take advantage of the moves when they breakup/down.

Price Discovery and Valuation

When markets are active with thousands of traders placing bids and offers, they tend to be transparent. The price discovery process can be relatively easy. Price discovery is not the same as valuation.

The process of trading uses a model-driven concept to determine that the current price is either overvalued or undervalued relative to future prices. This differs from price discovery which is a market-driven concept that determines the current price of an asset.

Terms such as fair value, focus on the future value of an asset relative to price discovery which is geared to determining the current value of an asset. For traders, price discovery provides a key metric for determining future price values.

For example, if you don’t know the price today, you cannot bet on the future price value.

What Influences Price Discovery

Several factors influence price discovery.

Some of these impetuses include:

  • Availability of an asset
  • The demand for an asset
  • The available information
  • Whether the asset is fungible (meaning it’s the same assets in all locations)

Bottom Line

The key takeaway is the price discovery has always been a key element in trading. Transactions are based on the ability of buyers and sellers to find a value that will allow a trade to take place.

Price discovery has taken place for thousands of years, initially starting with bartering and eventually moving into electronic marketplaces.

Each asset provides traders with a specific level of liquidity. Transparent markets generally have thousands of traders generating bids and offers to allow you to enter and exit a position at any time.

Opaque markets provide less price discovery, and generate more risk as entering and exiting with less price discovery can lead to wide swings in the value of an asset.

Price discovery and the value of an asset is not the same thing.  If you make a trade you generally believe that the value of the asset in the future will be either higher or lower than the current value.

It is a market-based concept where value is a model-based idea.

For you to be successful in your investment endeavors you must understand the price discovery associated with the assets you are trading.
Credit: Warrior Trading

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