So you want to buy (or sell) shares on the stock exchange. How is the price determined?
Think of it as a cattle auction, one expert told us.
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Marketplace listener Mike Eissenberg from Evergreen, Colorado, asks:
How precisely is the price set when I buy shares of stock? My request goes to Vanguard to buy a number of shares of a company. Then I wait and the purchase is executed. How does the bidding for price actually take place? I presume I don’t simply get the last price posted … because that was for a [previous] buyer. And if I don’t prescribe a [purchase] price, how does the price get determined?
When you log on to your account with Vanguard, Fidelity or another investment company and you want to buy shares of stock, you can make several different kinds of orders. They include a “stop” order, a “limit” order, a “stop-limit” order and a “market” order.
The first three allow you to set parameters on the price you’re willing to pay for a stock or an exchange-traded fund. But a market order means you’ll buy at the best price available at that moment, in other words, the market price. This very common type of transaction implies that an owner is already willing to sell those shares at that price.
Let’s say you want to buy 100 shares of IBM. Your order will go to a broker, said James Weston, a finance professor at Rice University.
“In the old days … that order would go down to the floor of the New York Stock Exchange. And it would literally be walked over on a piece of paper to the physical spot on the exchange where IBM shares were traded,” Weston said. “If I had an order to buy the shares, it would wait for somebody to show up on the other side who said, ‘Hey, I would like to sell 100 shares.’”
A middleperson, known as a market maker, would see who wants to sell and who wants to buy, then cross the trade at the current market price, Weston said.
As for where that price came from? “That price comes from all the people all over the world who are submitting orders to buy and submitting orders to sell,” Weston said.
But now, everything tends to be done electronically, allowing your Fidelity or Vanguard order to be filled more quickly. Your order will be executed when you and the seller put in a market order at the same time, Weston said.
If you want to buy shares, and there is no seller, the market maker will step in as the seller to ensure there’s a “smooth and orderly market,” Weston said.
If more buyers come in and nobody wants to sell, the market maker will usually raise the offer a little bit. As that price goes up, more people will be willing to sell, Weston said.
“So just like if you were at a cattle auction and somebody was saying, ‘Would anybody want to buy at this price? Would anybody want to buy at that price?’ The process is exactly the same. There’s an auctioneer, who’s basically standing in between the people that want to buy and the people that want to sell. These days, that auctioneer is usually a computer algorithm. But that computer algorithm was written by a person,” Weston said.
At a big brokerage, tons of orders are happening at once, so the company may clear the trade internally, Weston said. That means it will match orders between its own customers.
Our listener, Eissenberg, also wanted to know: If you’re not setting your own price in a market order, what’s stopping your brokerage from charging a price for the stock that’s higher than what the market will bear?
All brokerage firms have a fiduciary responsibility to give you the best bid or offer on the market, Weston said.
“People get sued for offering prices that are even a fraction of a penny away from the best price,” Weston said. “Because if you add it all up, it’s billions of dollars.”