Price movements across all markets can be traced back to the same source: supply and demand. This most basic and fundamental law of economics truly governs the price fluctuations that we see every day in the world around us. When the demand of something rises, then that product can command a higher price in the market place, as consumers line up for more units. Similarly, when the demand of something falls, then the price of that item will most likely fall, as businesses need to find ways to stimulate interest. When the supply of something rises, there is then an abundance of that product in the market place, which lowers the price, or value, of each of these units. Conversely, if the supply of something falls, then there are fewer units floating around, which increases the price of each remaining unit.
We can apply this exact same logic to the financial markets. Using stocks as an example, we examine exactly how the market maker will react to an imbalance of buys or sells. If he is hit with a flood of buy orders, then he’ll look to raise his prices to entice traders to sell to him. At the same time, if he is hit with a flood of sell orders, then he’ll look to lower his prices to encourage traders to buy from him. This all stems from the fact that he is compensated by the bid-ask spread, but he needs to turn those shares over to realize that difference.
Even though we only examined stock prices, these laws apply to any financial product, or any business entity, for that matter. Equilibrium prices simply cannot escape the laws of basic economics.
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