THE ESSENTIAL GUIDE TO DEMAND, SUPPLY, AND MARKET EQUILIBRIUM

The forces of supply and demand determine the prices of most goods and services around the world. This applies more so than ever to tradable instruments like stocks, currencies, bonds, and commodities.

Regardless of the amount of analysis, forecasting, and predicting that gets done on TV and social media, it’s ultimately supply and demand that drives prices. Without buyers, prices can’t rise and without sellers, they can’t fall. Understanding how supply and demand works, and everything that affects supply and demand is therefore crucial to understanding any market.

Market equilibrium and imbalance

Markets oscillate between periods of equilibrium and periods of imbalance or disequilibrium. When supply and demands are balanced—market equilibrium occurs. For any given time frame, equilibrium occurs most of the time. This is when prices consolidate or trade in a relatively narrow range.

During periods of equilibrium, buyers and sellers agree on the price —but not on the value or the future direction of the price.

Trends occur when there is an imbalance between supply and demand. When demand outstrips supply, buyers need to pay higher prices to find new sellers. Prices will then move higher until they reach a price where demand and supply are once again in equilibrium.

The opposite occurs when supply exceeds demand. Prices will then fall as sellers begin to accept lower prices to find buyers.

Supply and demand vs. support and resistance

Importers and exporters buy and sell currencies to facilitate trade. Producers and manufacturers buy and sell commodities because that’s why they exist.

It’s always worth remembering that the largest participants in any market are continually buying and selling in the background, regardless of the price or the latest news. Long-term sustainable trends occur when their businesses require them to buy more than they sell or vice versa.

Speculators, retail traders, and other active participants react more to changing sentiment and news flow. Their activity causes the price movements that occur within the longer-term trends.

Price sensitivity and equilibrium

There is an old saying in the market that says, “The price went up because there were more buyers than sellers.” This is probably true, but it would actually be more accurate to say that the buyers were more aggressive than the sellers.

Prices really only move higher when buyers are prepared to pay higher prices. Prices only fall when sellers are prepared to accept lower prices. There may be more buyers than sellers at a given level, but if they aren’t prepared to pay up, the price won’t move.

This is where price sensitivity comes in. The sharpest rallies and corrections occur when traders are more concerned with getting the deal done than they are with the price at which it gets done. This often happens when traders are motivated by fear, greed, or loss.

When traders get stopped out of a trade, they may act out of the fearof losing money. When traders chase the latest momentum stock, they may act out of the fear of missing out, known as FOMO. When a short squeeze occurs; short sellers have to close their positions because their potential loss is open-ended

Anyone who trades using charts will know that support exists at prices where demand is likely to outstrip supply, and resistance occurs at levels where supply exceeds demand. This is true—however, it’s important to remember why this happens. Buyers tend to place their bids at support levels, leading to increased demand at those levels. Sellers place their offers at areas of resistance, leading to an increase in supply.

Support and resistance levels tend to hold when there are no other forces at work. However, when other factors lead to changes in demand and supply, these levels can be breached quite easily.

What affects supply and demand?

There are numerous variables that can affect market equilibrium and how supply and demand affect prices. It only takes an increase or decrease in either supply or demand for prices to begin moving. This can occur as a result of new information becoming available or changing market sentiment. However, changes in supply and demand also depend on the different market participants.

To really understand how supply and demand works, it helps to consider all the potential buyers and sellers, and what may cause them to act:

  • In the stock market, there are very large investment funds, hedge funds, retail investors, and short-term traders. Bond markets include similar participants, as well as banks and central banks.
  • The currency market includes banks, funds, importers, exporters, central banks, and retail traders.
  • Commodity markets include producers, manufacturers, hedgers, and speculators.

The most significant players in each market don’t trade to speculate. Large equity funds receive regular inflows which need to be invested. Importers and exporters buy and sell currencies to facilitate trade. Producers and manufacturers buy and sell commodities because that’s why they exist.

It’s always worth remembering that the largest participants in any market are continually buying and selling in the background, regardless of the price or the latest news. Long-term sustainable trends occur when their businesses require them to buy more than they sell or vice versa.

Speculators, retail traders, and other active participants react more to changing sentiment and news flow. Their activity causes the price movements that occur within the longer-term trends.

Price sensitivity and equilibrium

There is an old saying in the market that says, “The price went up because there were more buyers than sellers.” This is probably true, but it would actually be more accurate to say that the buyers were more aggressive than the sellers.

Prices really only move higher when buyers are prepared to pay higher prices. Prices only fall when sellers are prepared to accept lower prices. There may be more buyers than sellers at a given level, but if they aren’t prepared to pay up, the price won’t move.

This is where price sensitivity comes in. The sharpest rallies and corrections occur when traders are more concerned with getting the deal done than they are with the price at which it gets done. This often happens when traders are motivated by fear, greed, or loss.

When traders get stopped out of a trade, they may act out of the fear of losing money. When traders chase the latest momentum stock, they may act out of the fear of missing out, known as FOMO. When a short squeeze occurs; short sellers have to close their positions because their potential loss is open-ended. These are all examples of supply and demand that is not sensitive to price. In these cases, traders taking the other side of a deal can keep moving their prices, because they know the supply and demand will follow.

The opposite occurs when large investment funds enter and exit positions. If a fund manager decides a stock is a good investment at $50, they may be prepared to spend millions at that price, but they won’t chase the stock higher. The price isn’t going to fall below $50, but it won’t necessarily rise either. Demand will then be very static.

Similarly, if the fund manager decides to sell the same stock at $100, the supply becomes static. The price won’t rise above $100, but it won’t necessarily fall.

Conclusion

The key to figuring out what supply and demand mean for any given market is working out who the buyers and sellers might be. That may be easier said than done, but looking at where volumes increase and where prices move rapidly on low volumes can give you some clues.

This is precisely what technical analysis sets out to achieve. However, viewing the market in terms of its participants can give you an even better picture of how supply and demand may move prices.

All content is provided for your information only.

This article may contain opinions and is not advice or a recommendation to buy, sell or hold any investment. No representation or warranty is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however we have put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing.

One Financial Markets expressly disclaims all liability from actions or transactions arising out of the usage of this content. By using our services, you expressly agree to hold One Financial Markets harmless against any claims whatsoever and confirm that your actions are at your sole discretion and risk.

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