Laws of Price: Prices Are Set At The Margin

In a free market, a prevailing price means just one thing: that the demand and the supply are (for a moment) equal at that price.

In a grand sense, this is not a very powerful meaning: we conventionally think of the value of portfolios as the sum of the products of the positions in every investment and the last price of the particular investment. So with 1,000,000 shares of IBM trading at $200.00 a share, this would have a value of $200,000,000.00. But if someone holding this position were to try to convert it to cash all at once, he would almost certainly net less than $200,000,000.00: his position is equivalent to about 25% of the average daily volume of the stock, and it is unlikely that buyers would arrive conveniently to absorb the additional sales that he has introduced, and leave the stock price unaffected.

But in a microscopic sense, it is quite a powerful meaning. In particular, if there is reason to believe that a realistic investor would want to buy rather than sell (or vice versa) a particular position at a given price, then it does not matter that this tendency would be exhausted with just a tiny position: the price cannot be expected to hold, other things being equal.

The latter fact is central to my understanding of the pricing of financial risk.