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.