Welcome to the fourth episode in the How to Day Trade Using Price Action series!
In today’s episode, we will take a look at supply and demand. This might sound like a boring topic, but I don’t think it is that boring. It’s actually a very important topic, and you need to understand the laws of supply and demand in order to be trading successfully with price action. This is because supply and demand and the relationship between them is the foundation of all price action.
We’ll try to make the topic a bit more fun to learn, with some silly examples and funny pictures. I might even throw in a funny cat somewhere…
So let’s jump right in and begin with the most boring part of this video (the official definition according to the economists)…
Wikipedia defines supply and demand like this:
In microeconomics, supply and demand is an economic model of price determination in a market. It postulates that, holding all else equal, in a competitive market, the unit price for a particular good, or other traded item such as labor or liquid financial assets, will vary until it settles at a point where the quantity demanded (at the current price) will equal the quantity supplied (at the current price), resulting in an economic equilibrium for price and quantity transacted. (Blah blah blah…)
Okay, so what does that wall of text mean for us traders? Why is the law of supply and demand so important?
Well, it is because those forces determine the prices of stocks, currencies, futures or any other security or financial asset. In fact these forces determine the price of any goods or service that is sold anywhere on Earth as well (with some exceptions; like if there is a monopoly, oli-ga-paly (oligopoly) or cartels, price fixing or some illegal or government-run operation.
But when there is a free market and free pricing, then the forces of supply and demand will dictate the prices.
Supply indicates sellers. In our case, it means securities or financial assets, like shares or currencies that are offered for sale. It can also be real-estate, commodities or futures contract.
Demand indicates buyers. This refers to the number of stocks or futures contracts that traders want to buy. So the people who want to own the stock or currency creates the demand.
The more buyers you have, the stronger demand you will have. The more sellers you have, the more supply you will get. That is a simplified model of course. In reality there could for example be only a few sellers, and thousands of buyers. But those few sellers could be offering more shares than those thousands of buyers can afford.
Therefore, it is not about number of sellers or buyers, but the number of shares or contracts that traders are looking to buy or sell. Often these two go hand in hand, but it is still important to understand the difference.
Think about the stock market and a stock like, let’s say, Tesla or Netflix. There are perhaps a few hundred institutions; like mutual funds and hedge funds in addition to the major owners who could be individuals that own the most part of the company and then there are tens of thousands of small-time investors who own a few shares.
When we talk about buyers and sellers, we don’t refer to the exact number of people or institutions of course. It is more like the combined dollar amount; the combined force that buyer and sellers are bringing to the table. So that’s important to keep in mind.
If you’re one of the people who read discussion boards or Facebook groups you might have seen stocks that are hyped up and it seems everybody wants to buy a certain stock. In reality, even if there are thousands of people starting to sell a stock XYZ because of some news, their combined dollar amount, their combined demand, might be peanuts compared to the capital that a mutual fund wants to buy the stock for. Don’t listen to rumors online. This is very important.
Here’s an example that will explain the whole thing with supply and demand and how everything works:
It is a hot day. Mr. Cat sits at his lemonade stand cashing in on the exceptionally hot weather. Most people who pass by stop to buy a glass of that cold refreshing lemonade. There is big demand for Mr. Cat’s lemonade. Business even goes so well, that Mr. Cat can raise the price for a glass of lemonade from 50 cents to a dollar when he only has a few glasses of lemonade left. And as people see that Mr. Cat is about to run out of lemonade, they happily pay one dollar for that sweet cold lemonade, and Mr Cat earns even more money.
At lunchtime, Mr. Cat goes inside to get more lemonade to sell. After lunch, Mr. Cat again sits down at his lemonade stand. Now, he has even more lemonade to sell for a dollar per glass, and already sees himself making a killing. But, now all of a sudden the sun is shaded by black clouds, and it starts raining. All the people that are out, they just run past the lemonade stand. Nobody is buying. There is no more demand.
Now Mr. Cat has all this supply of lemonade, but nobody is buying. There is no demand for lemonade at one dollar per glass. It is good lemonade, but the market is not in need of the lemonade as it rains and it is colder.
In order to get rid of his supply and be able to call it a day and go back inside, Mr. Cat lowers the price for the lemonade. Instead of charging 1 dollar or 50 cents, he decides to set the price at 25 cents, and every buyer of lemonade gets an entire bottle of lemonade to bring home. That’s a good deal. Now, people start buying again, the price appears to be cheap and it seems like a good deal.
Mr. Cat is able to sell his lemonade and he gets to go back inside to dry up.
So, what do we learn from this, and how does it relate to day trading? Well, when there is a lot of demand for a stock and there is limited supply, the prices will rise. Because traders will pay more and more in order to own the stock. That is often because they are afraid to miss out on the big move that the stock is making. They all want a piece of the action. So when the demand is bigger than the supply, prices will rise. If there are 1,000 shares available, and there are 5,000 traders who want to buy one share each, the market maker can increase the price as long as there is somebody who buys.
When traders find the prices to be too expensive, the prices will stop rising and start to consolidate or fall, until more traders find the prices to be reasonable.
At some point when the price of the stock has increased so much that a lot of the traders who bought earlier now want to sell, in order to secure their profit. So 10,000 shares are offered to the market but there are only 4,000 buyers left who want to buy one share each. Now there is too much supply, and too few buyers – too little demand – and this means that the price will start to fall. The supply is bigger than the demand. So the prices will fall until more and more traders again find the stock to be cheap and worth buying.
This relationship between supply and demand is present in the markets all the time, in all time frames. It doesn’t matter if you’re a scalper, a day trader, a swing trader or an investor – you can use this information. The relationship between supply and demand will be shown in the chats. And once you can read the charts, you will be able to take advantage of this knowledge.
In the next video, we will discuss how you can identify supply and demand in the markets by reading the charts like a pro.
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