Supply and Demand

The concept of Supply and Demand has an interesting use in the financial markets. When the price of an asset trades at one level and that trading leads to the formation of an area of interest on future tests by price, then this area can be viewed as a potential supply or demand area depending on where it is in the context of the trend.

Supply or demand areas can be formed because of interest from institutions at those levels, a previously traded area, a psychological number or even an area where many traders will tend to put their stop loss orders.

Let's take a look at some more supply and demand concepts now.

Supply and Demand Guidelines

Support can be viewed as demand. This is because it’s a more accurate representation of what is actually happening in the market. If a price area is to become support all that really means is that there is demand for the stock or market in that support area. This tells us that people want to buy and do so with real money to create that support area.

We view resistance as supply. This is an accurate representation of what is taking place in the market in those resistance areas. If a price area is to become resistance all that really means is that there is overhanging supply of inventory (the stock or market) that traders want to sell in that area. Real shares are sold and if there are more shares available for sale than there is demand to buy them, the price will drop as traders attempt to exit their positions or enter new shorts.

On each rally to resistance or decline to support the trader must assess the depth of penetration into that area of resistance or support. The deeper the level of penetration into that area, the greater the odds of overcoming that area the next time the price tests that level.

As prices move sideways away from prior supply or demand areas, those supply or demand areas become less significant on price retests. The longer the sideways movement, the larger the new area becomes in relation to prior supply or demand. It is up to the trader to assess which area is greater, prior supply or demand or the new area being created, and if prior supply or demand is more likely to hold or fail on future price tests. The size of the supply or demand area, and the distance between different supply and demand areas, will suggest the odds of overcoming the prior supply or demand area.

If a price breaks a supply (resistance) area overhead that is much greater than the demand (support) area below, the odds of a move lower are high. More sellers will step into the market because they see a good chance to get a decent price for the inventory they already own or they see a good opportunity to open a new short trade.

If the price breaks down through a demand (support) area that is much greater than the supply (resistance) area above, the odds of a move higher are likely. More buyers will step into the market as they see the price is on sale and is a good bargain.

Very loose supply or demand is made up of simple pivot highs and lows. There is not a tremendous amount of buying or selling at those levels to stop future price tests. However, there are different levels of pivot significance and we will discuss pivots in much detail later in this Wiki.

Tight supply or demand is made up of overlapping candlesticks and will form congestion areas, bases or holding patterns.

In a strong trend, minor or loose supply or demand points (pivots) will tend to hold on price retracements.

The depth of penetration into a supply or demand area will suggest the ability of prices to move through it on subsequent price tests.

Supply and Demand is relevant in all timeframes. Traders should assess it in the larger timeframe and then trade it in the shorter timeframe for better entries and exits. There will always be more power to supply or demand areas in larger timeframes over smaller timeframes. For example, if you are a Day Trader the charts that you will likely use are the daily, 60, 15, and 5 minute charts. The daily chart will always show you greater supply or demand areas than the 60 minute. The 60 minute will have greater supply or demand areas than the 15 minute and so on.

If price builds a new area of supply or demand area while you are in a trade expecting your target to be reached, it can affect whether prices will be able to make it to your intended target. For example, if you are long and price rallies and forms a congestion area, then falls below it, there will be difficulty moving higher back through that newly formed area and you may not reach your price target.

The length of a base in relation to a prior area of supply or demand will suggest the probability of a larger movement after the breakout or breakdown. If the prior area of supply or demand is far away prices may have an easier time moving freely. This is called trading in a "Price Void". Trading within a price void, after pattern formations like bases, is a primary key to successful trades. You always want there to be a lot of room between supply and demand points for the price to move through. If, for example, the next resistance area is only 20 cents or pips higher, and you are long, it may not be intelligent to assume prices will move to your price target if it's 80 cents away.

Movements of Price between Supply and Demand

Traders will bid to buy at prior demand and offer to sell at prior supply which can create enough buying or selling pressure to form a reversal at these points. Prices move between areas of supply and demand or create new areas of supply or demand which will affect future price movements. You must assess how potent an area of supply or demand is and update your trend bias as new information enters the marketplace.

When there are price voids that are free of choppiness or congestion to the left on the chart, prices will have better odds of moving freely and more rapidly through that area. When there are multiple areas of congestion to the left on the chart, prices are more likely to struggle and move in a choppier manner.

As prices move sideways, an area of supply or demand is created. A breakout or breakdown from this sideways area has good odds of working out for the trader if the next area of supply or demand is far away in terms of price and there is some kind of tradable price void.

Prices will tend to move in the path of least resistance (a price void). The trader's job is to assess the path that prices will likely move.

A rounding top formation is bearish and more difficult to overcome than a traditional V top where the supply is not as heavy. Many more trades would have taken place in a rounding top which can be seen as a kind of internal struggle between the bulls and the bears. The first pullback after a breakdown from a rounding top will likely result in failed buy patterns as it absorbs the overhead supply. A second buy pattern will have better odds of advancing through the rounding top high since some of the supply was absorbed by the first buy pattern unless there has been a complete breakdown in the market.

It would be wise to anticipate sellers in the area of prior highs and unfilled gaps higher. Anticipate buyers in the areas of prior lows and unfilled gaps lower. The odds of reversals at these points are good especially if you combine the elements of trend analysis with support and resistance.

Moves higher to resistance absorb that supply and make those highs less potent on subsequent tests. Moves lower to support absorbs the demand and makes those lows less potent or significant on future tests.

The wrecking ball concept is a good analogy for supply and demand being absorbed by price tests. The first hit with the wrecking ball may not break down the wall but after a couple of swings the wall crumbles and the wrecking ball moves freely through the wall without effort. Every test of supply or demand weakens it.

Each time a high is challenged by prices the supply that was there is being transferred. Topping tails will absorb overhead supply as aggressive selling took place there signified by the topping tail. Once the high has been overcome it will then become demand on future pullbacks to it. Resistance, once broken higher, becomes support.

If a move occurs leaving no gaps, congestion or choppiness (this is a momentum move) then look further to the left on the chart to find your next area of supply or demand. Unless the stock or market is making all-time highs, there will always be an area of supply to the left on the chart.

At this point, we should have another look at the basic cycle with the 3 trends and add in the supply and demand areas as well as the price void. Keep in mind that the first area of supply is the prior high and the first area of demand is the prior low. However, if the supply or demand is not heavy then prices will be able to move through those areas without difficulty. Figure 5.6 highlights this.

Your job as a trader is to take the middle chunk out of the move, not the entire move from top to bottom. If anyone is telling you that they can pick the exact tops and bottoms in the market they are lying to you and probably have never made a real trade before. Don’t focus on getting every last bit of a price move; there is enough money in the middle chunk of the move to make the kind of money that everyone else dreams of.

Figure 5.6: The Basic Cycle with the 3 trends highlighting supply, demand and price voids. This can be any timeframe from a 1 minute chart all the way to a monthly chart.

For more on the Basic Cycle please refer back to our Wiki on Price Action Analysis. It is such as simple yet powerful concept to help get traders thinking in repeatable patterns. CLICK HERE to go to the specific section that talks about the Basic Cycle and this will make the above picture of movements between supply and demand so much more clear.