Though prices fluctuate throughout any trading day, for stocks with a lot of market participants, the difference between what sellers accept and what buyers offer may only be about a penny apart at any given time. The difference between the price buyers bid and what sellers ask is called the bid-ask spread. Stocks with a low level of market participants may have a wider spread between price offers and asks.
To help understand how this happens, we can think about guessing how many jellybeans are in a jar. When only a few people play the game, the guesses will be far apart from each other, and likely far apart from the actual number of jellybeans. However, as more people guess, answers will start to converge around the right number. According to the law of large numbers (also called the wisdom of crowds) as more people participate, the average of all the guesses will move closer to the actual number of jellybeans. The average of all guesses may even be more accurate than the closest individual guesser.
The jellybean jar can show how stocks with a high number of market participants may have more of a convergence of price views than stocks with a lower number of participants. When the difference in bid-ask spreads is smaller, it can make it more likely sellers' asks will match buyers' bids. More matches in seller and buyer prices can result in more transactions. Liquidity describes how often transactions occur, with assets having high rates of transactions considered as having high liquidity.
We can also think about jellybean jars to understand investor behavior. If we think of jellybeans as the earnings a company will make, investors try to predict how many will be in the jar at some point in the future. Some will try to estimate a year ahead while some might project several years ahead. Some will have more optimistic predictions than others. Individual investors may continuously adjust their view about how many jellybeans there will be based on new information about a company or the overall economy. Even if there are a lot of guesses, there will never be complete agreement on how many beans will be in the jar. This disagreement keeps transactions going, as sellers may think the jar has as many jellybeans as it can hold, while buyers may think there is still room for more.
May 4, 2022
Markets Demystified is published the first and second Wednesdays of each month,
and is meant to help readers understand how stock market investing relates to household and personal finance.
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