What is Stock Supply and Demand?

September 27th, 2013
in contributors, syndication

Online Trading Academy Article of the Week

by Sam Evans, Online Trading Academy

In my nine years of studying the markets and actively trading, I have been introduced to and come across various techniques on how to enter and exit positions in the FX markets. Some of the strategies were complicated, others were far more technical and relied on a variety of different indicators to get the correct signal when to buy or sell. However, over time I realized the most important thing a trader needs to accomplish in his or her day-to-day routine, is the ability to be able to recognize an opportunity and take it when they see it. The longer it takes, the more signals you require, and the more emotional you can get, the harder this simple action becomes. I like many others, realized that I needed to keep things as simple as possible and allow myself to recognize an objective trading opportunity when I saw it and execute my plan without emotion.

Follow up:

So this brings us to the question: why use supply and demand? Having worked with and taught thousands of students around the world, I have noticed that the majority of the time they expect me to show them complicated charts and various squiggly lines and patterns drawn across the price bars to help me make a trade. Let’s face it, if you pick up the average book about technical analysis which you can find on Amazon, most of them will have those squiggly lines and complicated chart patterns, so that’s what people are used to! When I show people that really all it takes is nothing more than a simple candlestick chart to be able to recognize a trading opportunity in the markets, they raise an eyebrow in question, or a big smile appears on their face when finally they realize that there is something simpler out there.

In a previous article some months ago, I wrote about one of my heroes Albert Einstein and how one of his most famous quotes stated that the most complex questions in life always have the most simple answers. In the context of trading I believe that there couldn’t be a more true statement. In the reality of how markets work, we never really know what’s going to happen next. This is a fact that everybody needs to accept right from the start of their trading career. We can take a strategy and use as many different inputs as we like to try to help us to gauge direction in the market, however no set of tools will ever give us a guarantee of success. Yet, people still search for the Holy Grail. Trying another indicator or looking for the next wonderful chart pattern, all of which inevitably end up in further frustration and emotional peaks and troughs for the trader. You never want to find yourself in a position where you keep adding on layer and layer of complexity to your charts.

The more and more information you use to try to find a trading opportunity, the less likely that you are going to be focusing on the one true thing that will always give you the clearest idea of price action, mainly price itself. By focusing on the ancient laws of supply and demand, our students respect price and price alone and the dynamics which dictate the movement of price in any free-flowing market. At the end of the day, if I’m going to make a decision whether or not to buy or sell a currency pair, I want to make a decision based upon the hard evidence that is clearly in front of me. Price is the only thing that will give me that information. What is glaringly obvious when you start to incorporate an understanding of supply and demand onto a price chart, is that you can actually see when major activities of buying and selling have taken place on the charts and if you look at this the right way, you can also understand what this means for upcoming trades as well. Would it not make sense to buy in an area where demand has shown itself to be greater than supply? Would it also not make sense to be selling at an area where supply has shown itself to be greater than demand? The rules clearly state that if demand is greater than supply prices must go up and if supply is greater than demand prices must go down. Our job as objective and disciplined traders, is to simply incorporate this dynamic into our trading activity.

Let’s take a look at an example and see what it shows us:

Click to enlarge

In this basic example on a daily chart of the Euro versus the US dollar I have highlighted a major area of supply and a major area demand on the chart. From this example we know for a fact that there were more willing sellers than buyers in the upper supply area and there were a greater number of willing buyers than sellers in the lower demand area. Knowing these two vital facts which are objective and purely based upon price, what the chart is telling us, is that we should know when prices are at supply we should look to sell and when prices are at demand we should look to buy. People will never make money consistently if they buy after everybody else has bought and will struggle on the short side if they sell after the majority has already sold. By recognizing this simple piece of logic, we can use demand and supply to maximize our gains when we are right and minimize the losses to the smallest level when we are wrong. When our students buy at demand zones and sell at supply zones, they have the greatest possible reward and the smallest possible risk, thus having  a huge edge when they speculate in the marketplace.

Trading is a competition which involves a transfer of money from the accounts of those who don’t know what they’re doing into the accounts of those who do. Most people like to make trading complicated and rely on tools to make the decisions for them like the example below:

Click to enlarge

In this example, I’ve applied two simple 20 and 50 period moving averages. We need to remember if we are going to incorporate technical analysis tools and indicators into our trading, every single signal that we get will always be based on price. This means that price has to move before it can send a signal to the indicator to tell me what to do. I don’t want a lagging indicator when I’m trading because I’m always looking for the best risk to reward ratio and I need to focus on price to give me the lowest risk trading opportunities at any time. This is where price and demand will always give you an earlier signal in advance, something that a technical indicator cannot possibly do. Can you see how in this example, the fast moving average crosses the slow moving average giving us multiple buy and sell signals? While a few of these are correct signals, they incorporate very large risks are very low reward and many of those signals come much later, after prices have already been going up or down. The signals are way too late and always punish the trader by decreasing the potential reward and increasing the overall risk. This is why looking to buy demand and sell at supply always gives the best odds of success. This is not a chicken and egg question. Price always comes before the indicator, not the other way round. If you remove price from a chart the indicator would not function. That is why I focus on price first and foremost.

This is a topic I could spend hours and hours writing about. In my own journey as a trader, having tried things from Moving Averages to Bollinger Bands, MACD and various oscillators, I found that the one thing which never let me down in the long term, is a solid understanding of how prices move and why they move in the manner they do so.  Below I follow up on this discussion about supply and demand, by talking about what is really happening at a deeper level and how institutions use this simple approach to the market, to maximize their own gains in their speculative activities.

Have you ever heard of the saying, “When in Rome, do as the Romans do?” I like to travel as much as I can in my spare time and see as many different cultures and places as possible. No matter where I go, I always like to respect the local practices and get myself as involved in their way of life as much as I can. I live by this famous saying whenever I am in a place or environment which is different to what I am used to on a regular daily basis. I think that there is nothing worse than visiting a foreign country and not immersing yourself in the way of life which goes with that nation or culture. Not only can you blend into the environment in a much smoother way but you also learn more about where you are and the whole experience becomes a far more rewarding one as well. It’s a win-win every time.

Well, I also found that when it comes to trading the financial markets on a daily basis, it also rewards me to “do as the Romans do” once again, rather than fight what’s a natural part of the scenario. What I mean by this is that when I trade, I like to trade like the people who dominate the markets trade. As you may already know, the majority of traders speculating in today’s markets are more than used to being saturated with the level of information available to them via the mediums of books, seminars and of course the world wide web. There are literally thousands of different views on what causes market prices to move in one direction or the other and many different tools, indicators and strategies which attempt to predict the next move the market will make. While there is absolutely nothing wrong with the amount of information available to us, we still need to be very careful to ensure that we listen to words of advice which actually make logical sense. In the reality of market speculation, it can be very dangerous to come to the environment with a whole set of pre-conceived ideas. There are both good and bad practices one can bring to the markets but one thing is for sure and that is to understand the rules behind any game before you start to play it.

Whether we like it or not, the markets are a playground for the people with the deepest pockets. The more money you have, the more influence you can have on the moves which happen. Let’s face it; I can’t alone push the market higher because I simply do not have that kind of buying power available to me. Even if I got together with all of my trading friends and associates and took the same trades at the exact same time, I still would not be able to influence the direction of the moves in price. In today’s markets it has gotten to the point where not even one of the largest institutions in the world could single-handedly control prices but the big institutions do have the ability to stop the market in its tracks. This is simply a result of the pure size in which they have to trade. When I buy $200,000 worth of Euros on leverage in the FX market, there will easily be enough liquidity out there to sell that amount to me, thus creating an equilibrium point at that exact price I was willing to buy.

However, let’s say that I was representing a major financial institution and I was looking to get into a short position on the Japanese Yen with a size of $25 Million. How easy would it be? Well, thanks to the vast liquidity of the FX markets, I could probably still get a fill but nowhere near as easily as I could on my $200,000 example because in order to be able to sell all of that Yen, there needs to be buyers at the price I want to sell at and there also need to be enough of them. You see, the larger and larger my position size gets, the more and more difficult it then gets to find enough people to take the other side of my trade. This is the scenario which the large institutions face every day in the markets. They may be willing to buy at a price but are they always able? When this unique dynamic happens, it shows itself on the price chart, much like the example below:

Click to enlarge

On this daily chart of the AUDUSD, we can see a number of things. Firstly, we are in an obvious strong downwards trend and secondly, we can see in early August that there was a huge rally in prices in completely the opposite direction of the preceding trend. Now, ask yourself an objective question: What was really happening here? It can only be simply answered that someone with an intention to buy a large amount of Aussie Dollars had an order to buy which was big enough to pause the downward trend which was in place. They managed to buy some of what they wanted but clearly not enough as prices then went much higher. This is clearly shown on the chart and I know it was likely institutional buying, as retail traders don’t have accounts big enough to stop trends in their tracks. Taking this objective information, all I need to do is to be prepared to buy the market if it comes back to this area, as this is simply what the chart is telling me to do:

Click to enlarge

When the market returned to the area a few weeks later, the demand zone was hit again and this time the real move happened. There is no rocket science behind this or technical secret. It is a setup based purely on price and what the behavior of price is telling us. As I have highlighted, there was a demand area earlier in the year which failed, as they sometimes do, for nothing works 100% of the time. This is ok because when the ongoing risk to reward profile is solid, then we can afford to lose more times than we win and yet still make a profit.

When people ask me why I trade in respect to Supply and Demand, my response is always the same: Because Supply and Demand are the only true laws which govern the movement of prices in any markets around the world, so why wouldn’t I pay attention to them? Our job as traders is to just know objectively what a picture of Supply and Demand looks like on a chart and then use this information to place our trades for the future. By doing this with the guide of a well researched trading plan, keeping our emotions in check, and thinking like an institution, there really is no reason why any disciplined trader can’t “do what the Romans do” when they speculate in the markets. I hope you found this useful.

Take care and be well .... Have a great week



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