The Forces of Supply and Demand And its application

 

The Forces of Supply

and Demand

And its application.

 

Compiled by: Victor Andrews

The primitive forces of capitalism rule markets like the laws of gravity. Buyers and sellers provoke a battle to find a happy medium agreement in every market on the face of the planet.

As prices dance around on charts, traders are often looking to a number of reasons to explain price movements. And often-times, a number of reasons can be associated with these types of changes.

But at its core – every single price movement is denominated by supply and demand. Positive news means increased demand and lessened supply – equating to higher prices. Negative news usually spells lower demand and increased supply.

Supply and Demand Spelled Out

Supply is simply the amount available, while demand is the amount that is wanted. Think of supply and demand in the most simple of terms, from the standpoint of any market where buyers and sellers exchange goods. Let’s, for a moment, imagine that you are selling oranges from your own farm at a local market. And you don’t necessarily have to sell all of your oranges, because, after all, you can eat them just as easily as anyone that buys them from you.

But the higher price you can charge for your oranges, in general, the more willing you would be to part with them. If oranges are only fetching 1 dollar per bag, you might be willing to sell 4 or 5 bags. But as price goes up, you decide to make more available. All the way up to 10 dollars per bag, at which point you are more than willing to sell every last orange you have because you can easily take all the money you made and buy something else to eat.

The graph below is called a ‘supply curve,’ and it expresses this relationship. The red line indicates supply, which increases as prices move higher (located on the horizontal axis).

Supply curve, expressing the number of units available (vertical) at various prices (horizontal)

And on the opposite end of the spectrum, we have demand. Now think of the buyer-seller relationship from the vantage point of the consumer. The lower the price, the higher demand will be – the exact opposite of our supply curve. If oranges were only 1 dollar per bag, we’ll we’d want to buy as many as we could because it would be an extreme value. As price increases, our demand weaken because, after all – if oranges are 10 dollars per bag – we can easily find replacement products to use instead of oranges.

Demand curve, expressing the number of units desired (vertical) at various prices (horizontal)

And these two competing forces meet in the marketplace to decide the prices that will be paid and the number of units that will change hands.

This is how price is discovered in a free market environment, the same way that prices are set on trading platforms around the world and it can be expressed in the chart below:

Supply and Demand curve, expressing the most efficient price at which buyers and sellers can meet

Supply and Demand in the Forex Market

The analogy of oranges at a farmer’s market is not all too dissimilar from that which takes place every day in the currency market. In some cases, these forces are moving at such high velocity that new traders can have difficulty understanding the granularity of the details; but rest assured - the forces of supply and demand run true to markets whether you’re looking at a tick chart or real estate prices.

The FX market is one of the most voluminous on Earth, and the reason for that is the heavy demand behind the traded assets. Currencies are the basis for the world’s economy. Whenever one economy wants to trade with another economy (provided different currencies are used) an exchange will be required.

Supply and Demand at Work

Imagine that the Reserve Bank of Australia enacts an interest rate change. An entire chain reaction will be set in motion due to the forces of supply and demand. When rates increase, rollover payments also increase. This means that investors that are holding the trade open at 5pm Eastern Time will receive a higher rate of interest than they would have previously. Incentive has just increased.

So naturally, more traders will want to buy; and fewer traders will want to sell as the opportunity cost of doing so (the rollover payment) has just gotten more expensive.

An example of supply and demand in response to Interest Rate Increase

Price aims to find a comfortable point, and will increase until there are no more buyers willing to pay that price. At this point, sellers outnumber buyers, and price will respond by moving down.

An example of supply and demand in response to Interest Rate Increase

After price has moved down far enough (circled in blue), traders will come back into the picture, remembering in the increased interest rate and the additional rollover payment that can be had from holding a long AUDUSD position, and this lower price presents a ‘perceived value.’ As additional buyers enter the picture, price will move up to reflect this increased demand.

And then price will, once again, move so high that traders no longer want to enter the picture at that price level, and price will respond by moving down.

This is but one example of the Supply and Demand relationship; on one time frame… we can even see this relationship playing out in the tick chart of any currency pair.

Watch the Advanced Dealing Rates Window of Trading Station II during a fast market, as microcosmic examples of this phenomenon are taking place throughout the trading day.

This is the process of price attempting to find its fair value… it takes place on many different time frames in every market in the world.

In our next article, we’ll tie supply and demand in with support and resistance so that traders can look to use these principals to their advantage.

The Three Tenets of Price Action

 

The Three Tenets of Price Action

 

Talking Points:

• Price Action is a form of technical analysis devoid of indicators
• Traders can trade price action in isolation, or in addition to existing indicators and strategies
• We look at three of the most important aspects of Price Action Analysis

As traders, our job is not easy.

By opening a trade with the anticipation of profit, we are essentially trying to predict the future. And human beings can’t predict the future, so the very nature of our goal is somewhat of a conundrum.

This is where technical analysis can come into play. By observing the way that prices have moved in the past, we may be able to get an idea for the way that prices may move in the future.

Price action can be a valuable tool for the trader. The benefits of price action are numerous.

In this article, we’re going to discuss three of the most pertinent themes of the study of price action.

Tenet #1 Old support can become new resistance, and old resistance can become new support

One of the greatest aspects of price action is that its logical. Trends rarely develop in a straight line… usually an up-trend is a series of higher-highs, and higher-lows; while down-trends are often series of lower-lows, and lower-highs.

More interesting is the fact that in an up-trend, as prices are making higher-highs and higher-lows; the resistance from the previous ‘higher-high,’ can, in many cases, become a similar price level for the next ‘higher-low.’

In essence, previous resistance has become new support when prices are trending higher. Let’s take a look at the recent down-trend in the Aussie-dollar as an example:

Created with Marketscope/Trading Station II

Tenet #2 The past cannot predict the future, but it can help work with probabilities

One of the inherent difficulties of technical analysis is that the past is not always going to be indicative of the future.

Things change…trends reverse… and new information finds its way into the market at a break-neck pace.

One of the allures of price action is that it’s one of the cleanest ways to perform technical analysis. Price action doesn’t purport to tell us anything other than the cleanest interpretation of what has happened in the past (and I call this the cleanest because there is no mathematical function introducing lag into our technical analysis).

So, we can look to buy up-trends cheaply, or to sell down-trends expensively in the effort to get the probabilities on our side as much as possible.

If we see that the Aussie is trending lower or that the Sterling is trending higher – it’s not enough to simply buy or sell and ‘hope’ that profit produces itself. We need to be tactical in an effort to avoid The Number One Mistake that Forex Traders Make (looking for advantageous risk-reward ratios).

We outlined this approach from the perspective of a swing-trader in the article The Four-Hour Trader, a Full Trading Plan.

Traders can use price action to look to buy up-trends cheaply, or sell down-trends expensively

Taken from The Four-Hour Trader, a Full Trading Plan

While looking for risk-efficient entries won’t help you tell the future any better, it can mitigate the damage from the trades in which you are incorrect, while looking to maximize the benefit when you are on the correct side of the move.

Tenet #3 Price levels matter

As human beings, we can’t help but think in round numbers…

For example, if I ask someone how much they paid for their automobile, they’d likely round the amount up or down to give me an even number. As in, most human beings won’t respond with an exact dollar and cents amount… they’ll often just say ’39 grand,’ or maybe something like ‘40k,’ but rarely will someone respond with an amount like $39,256.23.

The reason is because, as human beings – most of us wouldn’t care about the $256.23 in the response… we just wanted a ‘ballpark’ type of answer, and as people we value simplicity.

This comes into trading as well.

Many traders will place stops or limits around whole numbers; like the price of .9000 on AUDUSD. And when the price on Aussie ripped down to .9000, those sitting orders changed the order flow (and the price) massively. 

 

Created with Marketscope/Trading Station II

Notice that on two separate attempts, price reversed at the .9000 level; and on the third attempt support of .9000 eventually yields as the down-trend in Aussie continues.

And shortly thereafter, old support of .9000 became new resistance.