An important aspect of stock market trading is being able to understand what is price discovery. Price discovery is all about spotting the point of confluence between demand and supply. It is a process that involves affixing the price of a security, asset or commodity. Another price discovery definition that helps you have a better understanding is that it is a process wherein sellers and buyers who are competing together affix an asset/security’s price.
The factors that go into the process of price discovery include demand-supply forces, the type of security, the availability of market information, the stage at which markets have developed and volatility among others.
In markets which are dynamic, price discovery is an ongoing process and doesn’t stop as securities are bought and sold constantly. The process is not a new one and has been in existence ever since marketplaces have been around. However, as e-trading and the stock markets have evolved across the globe, the process of price discovery has attained a key position.
The role of demand and supply in price discovery
Demand and supply forces are an important aspect of the market as they drive movement of prices. When there is a buyer-seller balance, it is indicative of the balance between demand and supply. The demand-supply balance can be spotted on the price chart when one looks at aspects such as resistance and support. Support is the area where there buyer demand is high and price doesn’t move down further. Resistance is the area on the price chart where there’s an increased seller demand, and price gets resistance and does not move up further.
With the help of these two levels, you can assess if sellers or buyers are dominating the market at a point in time. This helps traders assess price discovery areas or areas where there’s a demand-supply balance for a security or asset, and affixing of spot price.
What about volatility?
Volatility plays a key role in determining whether a buyer opts to enter or exit a position. In a highly volatile market, traders need to constantly use price discovery to understand what’s the apt price to shell out for a specific asset. Therefore, the process of price discovery comes into play in a volatile market situation.
Price discovery and valuation: what’s the difference?
Now that you know the price discovery definition and the process of discovery, it’s time to look at how price discovery doesn’t mean valuation, although they may seem similar. Valuation involves determining an asset or firm’s asset in the present time. Valuation is not a process that is driven by the market but price discovery on the other hand is driven by the markets. Valuation is analytical and is based on factors such as the cash flow that can be expected in the future and rate of interest, for instance.
An asset’s valuation is also referred to by terms such as intrinsic/fair value. This is not the same as market value, which is an asset’s price in a market. Market value depends on demand-supply forces, which can keep changing. The difference in the two values also reflects the difference between valuation and price discovery.
Importance of price discovery
It is not enough just to know what is price discovery but also to understand why it matters. It matters simply because markets are constantly changing and assessing whether a security is overbought or underbought helps those buying and selling. The trader can assess whether a security is trading below or above the market value. This helps them take a call on whether to open a short or long position. Price discovery helps establish whether the market price of a security is fair for both sellers and buyers.
Price discovery is at the heart of any exchange, determining the value of an asset and ensuring that buyers and sellers come together to arrive at that value. The mechanism or process of price discovery is dependent on many factors.
One of the important factors is the demand-supply balance. When forces of demand and supply are in balance, price discovery ensues. It is important also to bear in mind that price discovery is not the same as valuation, although they sound like the same terms. Valuation is not driven by the markets and is all about the fair value of an asset, whereas price discovery involves the market price of an asset that is arrived at by buyers and sellers. A knowledge of price discovery helps the trader take long or short positions, and is therefore an important element for anyone interested in trading.