Understanding Supply and Demand (SD) Imbalances
Welcome to Episode 5 of Price Action Trading Series from MarketSecrets.
In this episode we are go to learn about “Supply & Demand“. Price Action Trading is nothing but capturing the market moves that happens because of Supply & Demand. So understanding Supply & Demand is the first step.
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What is Supply and Demand?
Capitalism rules the markets in much the same way as the law of gravity rules our planet. Buyers and sellers are in a constant and never-ending battle trying to agree on a fair price on the traded product.
The only reason why a price moves in any, and all markets, is because of the supply and demand. But there is an important point we have to remember. If supply is exactly same as demand, then price won’t move. For a price to move, there should be an imbalance in supply and demand. The greater the imbalance, the greater the move in price.
Why do imbalances occur?
The stock market, the financial world in general is dominated and ruled by big investors, institutions, central banks and professional trades. They have the ability and capacity to move and change the markets with thousands of orders. These orders create the so called supply and demand imbalances.
Daily news occurs and affects the world’s economies. Positive news usually increases demand, and reduces supply, leading to higher prices. Negative news usually decreases demand, and results in an increased supply, leading to lower prices.
The retailer and small investor ends up becoming the bait, the liquidity the professional traders need to fill many of their orders. They can’t sell if there are no buyers interested.
Every trader/institution has a different perception of fair price and future value.
Supply is simply the amount available, while demand is the amount that is wanted. Supply is the amount available at a particular price, while demand is the amount that is wanted or desired at a specific price.
As prices increase, a seller’s willingness to sell products will also increase. The opposite of this shows that as prices increase, we see demand reduces. Buyers will demand more when prices are lower.
Basics of Supply & Demand:
Let’s imagine that your partner asks you to purchase some mutton for dinner. You go to the market and see the price of the mutton you normally buy has almost doubled!
It’s now going to cost you twice as much to enjoy your mutton, you quickly begin to think how costly that meat is. You begin to look at alternatives, such as chicken or Fish, as replacement products with which you can get a similar result at a far lower cost.
While you may decide to pay the increased price of that mutton, you have to think of the market dynamics at work.
Not every mutton buyer would be interested in doing this, many would opt for replacement products because they could not afford the new higher price.
This is a living example of a supply and demand. As the mutton price increases, demand for mutton decreases.
The next week you go to the supermarket, and see that mutton is half of what you normally pay for it; it’s 80% off of last week’s price. Now you will think differently to the previous week.
You will be thinking that you can buy more while the price is cheap. Other customers are buying while price is cheap, you realise that if you don’t act fast, all of the discounted meat will be gone before you buy any!
This is demand at work again. As the price of mutton lowered, demand increased, not only for you, but the market in general.
This example is very similar to what we see on the stock market on a day-to-day basis. The markets move the way they move based on supply and demand imbalances, lack of demand or supply, excess of demand or supply. We just can’t change that.
The main thing you need to remember here is that stock market is traded by professionals and not by retailers. A hunter has all sort of traps to capture its prey, so do the big institutions. We are trying to combat professional hunters, as retailers we are their prey.
So we need to understand the demand and supply properly or in technical terms, we need to understand the demand and supply zones properly to eliminate this trap.
Types of Supply Demand imbalances :
There are 2 types of Supply Demand Imbalances.
- Extremes (valleys and peaks)
- Continuation Patterns (CP)
There are many variations of imbalances but everything falls into these 2 categories. You can easily recognize these imbalances in charts through practice and this is only achieved by a lot of screen time. Once you start to look for SD imbalances you will realize that they all look a bit different.
To identify them correctly as what they are (Extremes or CP’s) is the difficult part in the beginning. However just because they look a bit different does not mean they are not “Extremes” (Valleys/Peaks) or CP’s.
Imbalances and different car brands:
There are as many variations in such imbalances as there are different brands of cars (from Maruti to Ford, Mercedes, BMW, and so on.) They all have different colours and shapes, but they are all cars. The same applies to the types of imbalances that manifest themselves on a chart.
Why do you think you are able to make out the differences between different Ford models? The answer is because you’ve seen many of those cars throughout your life (you may even have owned a couple), you were interested in those models and you read about them in car magazines, articles and TV ads.
All in all, your brain is used to seeing them, so you can differentiate between almost identical models.
Trading and learning share the same mental processes. Practice and time are needed to distinguish between different imbalances from one another.
Remember these words Supply and demand creates price action, price action creates patterns and trading zones which we call “Support” and “Resistance”. These Support and Resistance are created by the demand and supply.
Let’s see how Supply and demand creates price action and how this price action creates Extremes and CPs in detail in the next 2 episodes.
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