What is price discovery and how does it work?
Price discovery is a process by which market prices are determined, largely by interactions between buyers and sellers. Learn more about price discovery, including what it is, how it works and why it matters in trading.
What is price discovery?
Price discovery – also referred to as the price discovery mechanism or price discovery process – is a method for determining the spot price of an asset through interactions between buyers and sellers.
Generally, the balance between buyers and sellers is an effective indicator of demand and supply in a market; and demand and supply are significant driving factors of price movements. This balance can best be seen when looking at levels of support and resistance on a price chart. Levels of resistance signify the point at which demand has started to decrease for an asset, which brings the price down. Support signifies the point at which demand starts to increase for an asset, which drives the price up – both assuming that supply remains constant.
Using these levels, traders and market analysts can see whether buyers or sellers are dominant in a market at any one time. This is important information, as it can enable traders to effectively gauge areas of price discovery; that is, areas where there is an equilibrium in demand and supply for an asset. This results in a spot price for the asset.
How does price discovery work?
Price discovery enables buyers and sellers to set the market prices of tradable assets. This is because the mechanisms of price discovery set out what sellers are willing to accept, and what buyers are willing to pay. As a result, price discovery is concerned with finding the equilibrium price that facilitates the greatest liquidity for that asset.
Price discovery matches buyers and sellers based on the number, size, location and competitiveness of that asset. One way that these different factors are determined is through auctions. Auction markets enable multiple buyers and sellers to compete until the middle-ground – or market price – is found. At this point, the market will be highly liquid as buyers and sellers are matched easily.
Supply and demand
Supply and demand are the two greatest factors which determine an asset’s price and which in turn, dictate how crucial price discovery mechanisms are for traders. For example, if demand is higher than supply, the price of an asset will increase as buyers are willing to pay more because of its scarcity – which favors sellers.
Equally, if supply is higher than demand then buyers won’t be prepared to pay as much as they perhaps would if supply was low. This is because an asset with high supply but low demand is easily available to purchase. As a result, the price often favors buyers.
In a market where supply and demand are relatively equal, then the price is said to be in equilibrium as there is an equal number of buyers and sellers – meaning that prices are fair to both parties. Price discovery enables traders to determine whether buyers or sellers are dominant in a market and what a fair market price is at any one time.
Attitudes to risk
A buyer or seller’s attitude to risk can greatly affect the level at which a price is agreed between two market participants. For instance, if the buyer is willing to take on the risk of a fall in price for the potential reward of a large rise in price, they might be willing to pay a little more in order to secure their exposure to a market.
This would mean that the price was set higher than an asset’s intrinsic value might otherwise dictate. In such a scenario, the asset is overbought, and it could expect a fall in the coming days or weeks. Risk can be calculated through a risk-to-reward ratio, and it is important for both buyers and sellers to keep their risks to an acceptable level by using stops and limits on their active positions.
Volatility is linked to risk, but they are not the same. Volatility is one of the main factors which determines whether a buyer chooses to enter or close a position in any particular market. Some traders will actively seek out volatile markets as they offer the potential for large profits. However, they could also incur a large loss.
When markets are highly volatile, it is important to keep assessing prices and discovering what is the right price to pay for an asset. For example, if a market is falling currently but has been on an uptrend for the past few days, it is up to a trader to assess – through technical analysis and fundamental analysis – whether that change in an asset’s price is because of a shift in the balance of supply and demand or whether it is down to other factors.
The amount of information available to both buyers and sellers can determine the levels at which they are willing to buy or sell. For example, buyers may wish to wait for key market announcements – such as the outcome of Bank of England or Federal Reserve meetings – to be made public before determining whether they wish to buy into a position or not.
In turn, these meetings and their outcome could increase demand or reduce supply, which means that asset prices might change in line with any changes that are highlighted in these market announcements.
Price discovery is different to valuation – which is the analytical process of determining the current or future intrinsic value of an asset or company. This is because price discovery works off market mechanisms which seek to establish the market price of an asset rather than its intrinsic value. As a result, price discovery is more concerned about what a buyer is willing to pay, and a seller is willing to accept, rather than the analytics behind what determines an asset’s price.
In this way, price discovery is more reliant on market mechanisms such as the microeconomic – supply and demand for example. With price discovery, investors have confidence that the price is being quoted at the true market price, and that the price is fair in the sense that it is an agreement between buyers and sellers. The reduced uncertainty surrounding an asset’s price in turn increases liquidity, while in some instances it also reduces cost.
Price discovery examples
In the chart below demand is decreasing as supply is increasing. Typically, this means an asset’s price will fall. As the graph shows, the two lines representing demand and supply eventually cross, representing a level that both buyers and sellers agree is a fair market price for an asset.
As a result, the asset will begin to trade at this level until there is a shift in the levels of supply and demand, which will require another period of price discovery.
Why does price discovery matter in trading?
Price discovery matters in trading because supply and demand are the driving forces behind the financial markets. In markets that are constantly in a state of bullish and bearish flux, it is important to constantly reassess whether a stock, commodity, index or forex pair is currently under or overbought, and whether its market price is fair to both buyers and sellers.
By assessing this, a trader can determine whether an asset is currently trading above or below its market value, and they can use this information as the basis of whether to open a long or short position.
Price discovery summed up
To help you understand price discovery, we’ve summed up a few key points:
- Price discovery is the means through which an asset’s price is set by matching buyers and sellers according to a price that both sides find acceptable
- It is largely driven by supply and demand
- It is a useful mechanism to gauge whether an asset is currently overbought or oversold
- It can help you assess whether buyers or sellers are dominant in any one particular market
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