This is a very basic question I had as I tried to understand the stock market. However, when I googled it, I got vague answers that it is based on supply-demand, it is based on how the company performs, etc. Finally, after a lot of searching, I found the answer and I'm sharing it here. This is based on my very initial understanding and I may be wrong. Feel free to comment and let me know if I got anything wrong.
The price of a stock that you see is also called the headline price. This is the price at which the last transaction took place. This is not necessarily the price at which you can make the next transaction. To understand more, let's understand the types of orders one can place.
There are two types of orders that one can place in the stock market:
For each of these order types, it could either be a buy order or a sell order.
In case of a limit order, you specifically say at what price you would like to buy/sell.
At any time there may be multiple people offering to sell at different sell prices. Anyone would like to buy from the seller who quotes the lowest price. The lowest of these prices is called the ask price. It is the lowest amount that you can pay to get one stock, right now. As different sellers put in their sell orders this might keep changing to reflect the lowest price possible buy price.
Similarly, there may be multiple people willing to buy at different buy prices. Anyone would like to sell their stocks to the buyer who is quoting the highest price. The highest of these is called the bid price. This is the highest amount at which you can currently sell one stock, right now. As buyers put in their bids, this will keep changing.
For example, consider the headline price of a stock is $52 and we have all these limit orders in place.
Headline price: $52
| Buy orders | Sell orders |
|---|---|
| 1 share @ $50 | 10 shares @ $55 |
| 100 shares @ $45 | 5 shares @ $57 |
| 5 shares @ $40 | 1 share @ $60 |
| 1 share @ $40 | 40 shares @ $70 |
| 10 shares @ $40 |
In this case, the buyer who is willing to pay the highest amount is the one who created the order of "1 share @ 50".
The seller who is willing to sell at the lowest amount is the one who created the order of "10 shares @ $55".
So the bid price is $50 and the ask price is $55. Right now as you can see there is a gap between the bid and ask prices. This is called the bid-ask spread. The smaller this gap, the more liquid (easier/faster to transact) is the stock.
When would a transaction take place? A transaction would happen when a buyer and a seller agree on a price. So right now with the gap in place, no agreements are happening. But let's say another seller comes along and says he's willing to sell 2 shares at $50 then this will go into the order book into the sell orders column.
Headline price: $52
| Buy orders | Sell orders |
|---|---|
| 1 shares @ $50 | 2 shares @ $50 |
| 100 shares @ $45 | 10 shares @ $55 |
| 5 shares @ $40 | 5 shares @ $57 |
| 1 shares @ $40 | 1 share @ $60 |
| 10 shares @ $40 | 40 shares @ $70 |
Now as you can see there is an agreement between a buyer and seller @ $50 per share. So a transaction would take place and this will be the updated headline price and order book:
Headline price: $50
| Buy orders | Sell orders |
|---|---|
| 100 shares @ $45 | 1 shares @ $50 |
| 5 shares @ $40 | 10 shares @ $55 |
| 1 shares @ $40 | 5 shares @ $57 |
| 10 shares @ $40 | 1 share @ $60 |
| 40 shares @ $70 |
This process will keep on going. Based on the agreements that the buyers/sellers come to, the headline price will keep changing. Since the headline price is always the price of the last agreement/transaction, it isn't a certainty that you can again buy/sell at the headline price. You can do so only if there is a corresponding seller/buyer who is willing to sell/buy at that price.
What is a market order? Market order means one is willing to buy/sell at the current bid/ask price respectively. In the case of market order, you don't specify any specific values at which to buy/sell. Instead, you buy/sell at the best price available at that time.
So consider the same scenario as before:
Headline price: $50
| Buy orders | Sell orders |
|---|---|
| 100 shares @ $45 | 1 shares @ $50 |
| 5 shares @ $40 | 10 shares @ $55 |
| 1 shares @ $40 | 5 shares @ $57 |
| 10 shares @ $40 | 1 share @ $60 |
| 40 shares @ $70 |
Now let's say a new buyer comes in and places a market order of 10 shares. The current ask price is $50. But there is only 1 share selling at $50. So he'll get 1 share at $50. Then the new ask price becomes $55. And he'll get the other 9 shares at $55. So finally the updated values would be:
Headline price: $55
| Buy orders | Sell orders |
|---|---|
| 100 shares @ $45 | 1 shares @ $55 |
| 5 shares @ $40 | 5 shares @ $57 |
| 1 shares @ $40 | 1 share @ $60 |
| 10 shares @ $40 | 40 shares @ $70 |
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