Demand & Supply

In the Skype trading room, we're got a number of traders that use "demand & supply" logic to aid their trading decisions. So here are some thoughts on Demand & Supply. After all, the market doesn't move becuase it touched some magic line. The market moves from zones of fair value to zones of imbalance. In this article we will explore the concept of demand and supply as it applies to the markets, and what the importance is to us traders.

1. Demand/Supply basics

Source: IMF.org

Demand and supply are the basic building blocks for any competitive market model. Since any competitive market is based on the exchange of goods and services for a value, in order for it to function there has to be some goods and services offered [supply] and people who are willing and able buy them [demand]. Supply and Demand are treated in microeconomics as if they were two separate things; in reality they are strongly interconnected. One cannot exist without the other. After all, to buy something you must have buying power which comes from something you sold to someone else (your labour for example?) and if you sell something to someone else then you must have first bought something (for example, some education that would make your skills desirable). 

The four basic laws of demand and supply are:

1. If demand increases (demand curve shifts to the right) and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.

2. If demand decreases (demand curve shifts to the left) supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.

3. If demand remains unchanged and supply increases (supply curve shifts to the right), a surplus occurs, leading to a lower equilibrium price.

4. If demand remains unchanged and supply decreases (supply curve shifts to the left), a shortage occurs, leading to a higher equilibrium price.

In an ideal open market, where economists can “model” supply and demand as if they were two separate entities, prices are defined easily, creating a base framework for allocating resources in the most efficient way possible. However, in reality this is not always the case. Monopolies and regulators in certain sectors or systems can define prices as they like regardless of buyers. Prices may also be manipulated by speculators unnaturally thus overriding basics laws of supply and demand.

How does the Supply curve work?

1. In order to maximize their profits, suppliers  want to offer more products and services as prices rise.

2. At certain price levels, when there is a good enough profit margin, suppliers will increase

their production without demanding higher prices in order to increase profits.

How does the Demand curve work?

1. Since money does not grow on trees, demand for goods and services increases as the price decreases.

2. Demand for different types of goods and services can be more or less reactive to shocks in prices and supply. 

Where buyers on the bid and sellers on the offer meet is called equilibrium. Equilibrium represents the ideal encounter between price and quantity. However, in reality equilibrium cannot be sustained and is a very dynamic concept. It's just a temporary point that may be reached from time to time for a brief period. In order for there to be change and/or progress, equilibrium cannot be maintained for long. 

2. Supply and Demand in trading

Trading in financial markets, whether on Equities, Fixed Income, Futures, Forex, etc. requires sellers and buyers just like any other competitive market. Supply and Demand applied to trading is all about spotting where buyers and sellers may be sitting (even if we can never be sure). 

However, trading from the retail side of things makes it more difficult to spot and exploit these areas because we do not have access to current order flow chatter. So shall we abandon all hope right here, right now? Of course not.

What we can do is look back (looking left on the chart) and define previous Supply and Demand zones with the expectation that in those zones will still harbour some sort of reaction next time price bumps into them. Sure, we are using lagging Supply and Demand information and we are making our trading decision based on historical data, not the current data. We also know that what has happened in the past will not necessarily repeat this time round. After all, we are dealing with probabilities and not certanties. If you want a guarantee, buy a toaster. Don't trade.

There is one important difference between classic Supply and Demand theory and the situation we face as traders: in the classic approach, suppliers generally stay suppliers (so for example Samsung will usually be a producer of tech items) and buyers remain buyers (the consumer will always be a consumer). However, in trading we can not identify certain participants as sellers or buyers. All participants in trading can be buyers or sellers at any one time, or even at the same time. 

So who are the buyers and sellers? Looking at the Foreign-exchange market – the most difficult market to get a grip on, since there is no central exchange – there are many participants in various classes and sizes. And each group of participants has it's own agenda that will be carried out each day/week/month. Are you competing against fellow retail traders or are you competing against someone with potentially more information than yourself?

Source: BIS.org

As we can see from the above graph, the FX market is a difficult and unequal playground. Banks are firmly in control of Forex. In spite of the healthy growth of retailers' market share, banks  remain in control. Also note that:

a. Banks generally acts in sync like one big cartel (even if the recent FX Probe is limiting the amount of information exchange that goes through the interbank pipe);

b. Many funds and insurance companies are extensions of banks (in the way that they, as institutionals, get fed some information that does not leak out into the public domain);

c. Retail traders are extremely fractured and can not act in sync (so despite the growing market share of retail traders, the buying power of this segment remains weak).

3. Supply and Demand on a chart

Finally the part that everyone was waiting for: how can we visually see previous levels/zones of demand and supply on our price chart? To get into the right mentality, think of what they represent. Here we have a chart without any markings other than ask and bid price lines. Supply and Demand zones indicate price turning areas, where price reaches a point where the balance has changed in favor of the participants. It's the tipping point where imbalance between buyers and sellers is at peak. When imbalance is at its peak, change in direction is bound to follow.

For instance, when the balance is on the buyers' side we see price going up. Evidently there are more buyers then sellers. However, once the price reaches a certain level, participants start thinking price is a little too expensive, and they start selling at new highs to maximize their profit. Additionally, certain participants would have exhausted their resources during their buying activity and there will be certain participants waiting on certain levels to sell too, which helps to create  a decent supply zone. 

Thus, we have fresh sellers entering  the market plus some of those buyers closing their long positions (with sell orders) and joining in as sellers. Price will hence be travelling down until it finds demand. What we're saying it that supply and demand zones don't represent magical decision points, but rather zones representing imbalance at its peak. 

Crude Oil – Daily Chart  

Source: FXCM Marketscope

In the chart above we have highlighted the imbalance zones that (after the fact) reveal themselves as swing highs or swing lows or consolidation areas. The reason why we're starting to view the orderflow imbalance areas on a Daily chart is because of the weight the Daily chart carries. If price action is a reflection of the market's current psychology, then the more time passes, the more transactions (and agendas from multiple players) gets included in the reaction. So we're looking a potentially larger amount of participants' views, when we're focusing on the larger time frames. That's probably the main reason why the signals that are generated via the larger time frames carry more weight: they implicitly carry a larger number of views/agendas than a 5Min or 15Min chart.

Crude Oil – 4H chart

Source: FXCM Marketscope

In the chart above, we have attempted to illustrate the way time frames cascade upon each other from larger to smaller. The chart is a 4H view of Crude Oil. There are Daily imbalances highlighted. The main reason it's important to know what your primary time frame is, is to keep you on the right side of the dominant flows. So if you were taking your stance from the Daily imbalance levels, you would look to play the subsequent 4H trend that initiated off the Daily imbalance, attempting to play it all the way to the next Daily imbalance. It doesn't always work like clockwork, but you need a structure to work with, so you don't get confused. 

You will see imbalances on all time frames – and you might be tempted to play them all. But then, you will notice that some hold perfectly, and some (like in the chart above) get pierced like a warm knife through butter. Why does this happen? The closest that we can come, as retail traders, to a legitimate answer is: the dominant flows had reversed, thus we are playing counter-trend.

So this leads us to the conclusion of how to create a viable plan around the imbalance areas:

1. Pick a larger time frame from which to highlight the areas.

2. Pick a smaller time frame from which ti initiate and manage the trades.

3. Use imbalance areas created on the smaller time frame, in line with the dominant flows, to compound the position.

4. Use imbalance areas created on the smaller time frame, that present themselves against the dominant flows, as places to reduce risk (take some profit), trail stops, or in any case actively manage the position. 

An imbalance area will generally create some sort of reaction. But whether it makes sense to play the reaction, or whether the reaction is strong enough to pose the question, is the resolving question that will separate a successful trader from a losing trader. The simple plan above is, we believe, a good way to stay on the right side of the market and not get caught fading moves.

4. The psychology behind these areas

Let's say you see a brand new laptop selling for $1000 on monday. You like it but it's a little expensive based on your current ideas. So you decide to postpone the purchase. The next day you walk past the same store and see the same laptop already selling for $1200! Of course you start to get upset and start thinking, ok...maybe $1000 was a reasonable price. But you still don't buy it. Then, the next day, the same laptop is selling for $1800!  “Darn” you think “if the laptop goes on sale for a price anywhere close to $1000, I'm going to pick it up a.s.a.p.!”.

That same reasoning goes on during the consolidation phases. If price is heading north, consolidates, then breaks north again with a good thrust, people will be anxious to pick it up “at value” back at/around the consolidation level (if it gets back there!) because they lost the train on the way up.

But what about swing highs/lows? Highs are important because many market participants may have bought close to or at the actual high for a move. When prices decline, the normal human response is not to take a loss but to hold on. That way, it is felt, there will not be the pain of actually realizing a loss. Consequently, when the price returns to the old high, those who bought at that level have great motivation to sell in order to break even, so they begin to liquidate. Also, those who bought at lower prices have a tendency to take profits at the old high, since that is the top of familiar ground. By the same token, any prices above the old high look expensive to potential buyers; consequently, there is less enthusiasm on their part, so they begin to pull away from the market.

To sum up:  the markets move on relentlessly on the back of demand and supply shifts. We shall leave the reasons behind such shifts to another place. For the moment, we have focued on the dynamics of demand and supply in any competitive market environment. We have seen what they look like on a price chart,  how to potentially use them to our advantage and why exactly do the markets react in that way.

Good Luck!

References:

1. http://en.wikipedia.org/wiki/Supply_and_demand

2. Imf.Org

3. Pring on Price Patterns – M. Pring, McGraw-Hill 2005