Supply and Demand

Supply and demand is the driver behind all price movement for any stock, currency, commodity; or indeed, anything that can be bought or sold in a free market.

To appreciate this, we must remember that there is always be a buyer and a seller for every transaction. The buyer has a maximum price they want to pay for something, whilst the seller has a minimum price at which they will sell it. In practice, the market is made up of many different buyers and sellers, all of whom have their own view of how much something is worth and looking to buy or sell different volumes.

Available buyers are looking always looking to purchase at prices lower than the available sellers are offering. This must be true, else buyers and sellers will already have transacted with each other at a price acceptable to both of them.

At any point in time, the difference between the lowest price someone is prepared to sell at and the highest price someone is prepared to buy at defines the spread.

Whenever there is significantly more buying interest than selling, then prices must move up to a price where there are sufficient sellers available to meet the other side of all buy orders. Conversely, if there is significantly more selling interest than buying, then price must move down to a price where there are sufficient buyers to meet the other side of all sell orders. Only when the selling interest is exactly the same as the buying interest does price remain approximately constant.

Typically, when there is a significant imbalance between the buying and selling interest, the spread will increase as buyers and sellers close to current price are quickly absorbed, leaving only those further away from each other. This can occur both at times of low volume when there are very few market participants willing to trade, as well as when the volumes of buyers or sellers increase substantially relative to the other.

To forecast price movements, we must quantify and compare the buying and selling interest at any given price level. The buying interest is known as demand, whilst the selling interest is known as supply. When there is an imbalance between supply and demand, then prices will necessarily move to try and restore the equilibrium.

Buyer demand will tend to increase at prices further below the current price. That is, the cheaper something is relative to perceived current value, the more traders will be prepared to buy of it. Similarly, seller supply will increase at prices above the current price. However, the relative change of buyers and sellers rarely changes in a linear fashion. That is the increase in the number of buyers between prices 120 and 130 will not be the same as the increase in the number of buyers between 130 and 140. Typically, orders accumulate zones, close to previous highs (for sellers) and previous lows (for buyers). These are levels where buyers and sellers perceive that they are getting the best value for money.

The two main elements that must be quantified are: 1. How many orders are remaining unfilled at a given level; and 2. How many additional participants are still entering the market at the current price to help propel price towards and then potentially beyond those orders?

Let's assume there is a large number of sell limit orders at a level not far above the current price. The sellers must find buyers who are prepared to trade at that level. However, it may be that current buyers only want to trade at a lower price. It will be the buyers view on whether they can get a better price or not that will determine the action they take.

If there is a lot of competition to buy at a level (demand) those buyers may just get in while they can, without attempting to negotiate or wait for a lower price. If there are a lot of buyers jumping into a bullish trend, the most likely scenario is that the sell limit orders will be quickly filled by those trying to buy and the price will then need to push higher to find more sellers. Conversely, if the price is already at a new high and interest in buying is limited, the sellers may need to compromise and agree to trade at lower prices where they can find buyers prepared to enter the market.

Taking advantage of supply and demand when trading requires an ability to quantify the number of limit orders at a level and the willingness of participants to fill those orders. Price charts can help to identify where buy or sell orders existed at a level at a time in the past. For instance, if the price was increasing, hit a level and then dropped, this tells us that there must have been an excess of sell orders at that peak level. Otherwise, the price would not have reversed. Similarly, if the price was decreasing, hit a level and then increased again, this tells us that there must have been an excess of buy orders at that low price level. Once we know this, our objective is to quantify the exact number of orders remaining at that level and compare this with an estimation of the willingness of participants to fill those orders.

In practice, it is predominantly the retail traders that fill the institutional orders. Normally, institutions are not prepared to increase their risk by entering at the current market price. Therefore, retail traders are lured into the market and encouraged to trade at the required levels. This can happen when the level coincides with trend line breaks, Fibonacci levels and other technical indicators. Or it may happen based on favourable news announcements or with rapid momentum moves in price suggesting to the naive that price will continue in the same direction

Whilst buy and sell limit orders create liquidity in the market, their presence does not directly impact the current price. This only occurs when a transaction is completed, typically by a market order being used to fill a limit order. The market order is used by a participant who wants to trade at the best price available right now, whilst the limit order provides the liquidity and determines the level at which the transaction occurs.

If the closest limit order is some distance from the currently displayed price, slippage may occur. In particular, large slippage is probably if there is high demand with only a few sellers available or significant supply with only a few buyers available. Once a limit order is filled, a new current price is set. Therefore, the current price on a chart always represents the agreed price for the last completed transaction.

The size and nature of candles on a chart can give significant clues about where trading has taken place in the past. For example, if there is a long-bodied candle on a standard candle chart, this means that price has moved a long distance in relatively little time. Therefore, relatively little trading will have occurred at prices contained within the candle body.

When new buyers continue to enter the market, the price at which they are able to trade will move higher as the closest sell limit orders are absorbed. Eventually, the number of buyers prepared to trade at the higher prices diminishes and the price starts moving up slowly. The higher the price goes, the lower the number of buyers that remain in the market and the less price will be able to move up. At the same time, as price increases, more sellers will be prepared to enter into transactions with those remaining buyers. At some point, the number of sellers will exceed the number of buyer and price will continue to fall again and the process starts over again. This explains why price generally follows a trend using a wave-like motion.

Typically, limit orders accumulate at certain price levels where the party placing the order can easily quantify their risk. This is best done at previous turning points in price, with a stop placed beyond the most extreme price achieved before price turned. The assumption is that if the price could not exceed a specific supply level, then at that point in time there must have been other sellers who were also looking to sell but did not get a chance before price reversed. The converse situation occurs at a demand level.