How Prices Reveal Information
A market price is not the average of every opinion. It is set by the best-informed traders at the margin, who buy when the price sits below their estimate of value and sell when it sits above. Their trading pushes the price toward the best-informed view and impounds information into it. The law then draws a line. An edge you earn from public research is legal, an edge you steal from inside information is not.
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Open full lesson page →Why it matters
Picture one stock and two investors who disagree. The price does not settle at the midpoint of their guesses. Whoever has done the work and is willing to trade keeps pushing the price until the easy profit is gone. That is why a price already reflects what informed people know, and why the leftover moves come from genuine surprise.
Worked examples
A stock trades at $100. Informed analysts who have studied the public filings think it is worth $110. What happens, and is acting on that research legal?
Informed buyers keep buying near $100 because it is a bargain to them, and their demand lifts the price toward $110, where the bargain disappears. Trading on your own analysis of public information is legal and is exactly how prices come to reflect information.
A manager learns of an unannounced takeover and buys shares before the news is public. Legal or illegal?
Illegal. Trading on material non-public information obtained through a position of trust is insider trading. The edge was stolen, not earned, and it erodes confidence that prices are set fairly.
Common mistakes
- ✗The market price is the average of everyone’s opinion. It is set by the marginal informed trader, so a well-researched minority can move it past the uninformed crowd.
- ✗Any trading on information is illegal. Trading on public information or your own legal research is fine. Only material non-public information crosses the line.
- ✗If prices already reflect information, gathering information is pointless. Someone has to do the costly research first, and informed traders are the ones who push that information into the price.
Revision bullets
- •Price is set by the best-informed traders at the margin
- •Informed trading impounds information into the price
- •Price equals the best-informed view, not the crowd average
- •Earning an edge from public research is legal
- •Trading on material non-public information is illegal insider trading
Quick check
In a well-functioning market, the price of a stock is best described as
Connected topics
Sources
- Mishkin (2018), Ch. 7Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.How efficient markets impound information through informed trading, and the role of insider-trading rules.