The order book mechanism
A stock exchange maintains an order book for each listed security — a real-time record of all buy orders (bids) and sell orders (offers) that have not yet been matched. The best bid is the highest price any buyer is currently willing to pay. The best offer is the lowest price any seller is currently willing to accept. The spread between them is the bid-offer spread. When a new order arrives that matches an existing order (a buyer willing to pay more than the current best offer, or a seller willing to accept less than the current best bid), a trade executes and that price becomes the new "last price."
What moves prices
Prices move when new information changes investors’ assessments of a company’s value. Strong earnings above expectations? Buyers raise their bids, pushing the price up. A profit warning? Sellers accept lower offers, pushing the price down. Macro news (inflation data, interest rate decisions) moves entire markets by changing the discount rate used to value all future earnings — when rates rise, the present value of future profits falls, and stock prices fall with them. Market sentiment, fund flows, and even algorithmic trading can create short-term price moves disconnected from fundamental value.
Market depth and liquidity
Not all stocks are equal in liquidity. For FTSE 100 companies, millions of shares change hands daily — you can buy or sell £1 million of stock with negligible impact on the price. For small-cap stocks, the order book may be thin: a single institutional order to buy £100,000 of shares could push the price up significantly. This liquidity risk is an important consideration for investors in smaller companies — the price you see may not be the price you get when you try to buy or sell a significant amount.
“In the short run, the market is a voting machine. In the long run, it is a weighing machine.” — Benjamin Graham
What this means for you
Understanding price formation helps you avoid three common mistakes. First: confusing noise (short-term price moves driven by sentiment and flows) with signal (changes in a company’s fundamental value). Second: not accounting for bid-offer spreads and market impact when trading — for retail investors in ETFs and large-cap stocks, these are tiny; in illiquid markets they can be enormous. Third: anchoring to a "target price" as if the market will find it — the market price is the collective opinion of all participants at any given moment, incorporating vastly more information than any individual investor possesses.