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Wednesday, September 19, 2012

Trading supply and demand

I believe most of us are familiar with the terms of supply and demand in economy. These help to determine prices for goods, services and also securities. If a lot of people are willing to buy some product, the price of it will increase. If, on the other hand a lot of folks would be willing to sell some product (get rid of it) the price of it will fall. If these two are in equilibrium the prices will probably stay at the same level for some time or fluctuate a bit. The principle of supply and demand is important in financial markets too. A smart investor or speculator will look for areas where demand increases and supply decreases to start buying and for areas where supply increases and demand decreases to start selling. 

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Now, this is easier said, than done, but for a trained eye it is not so difficult to see a shift between supply and demand in technical charts. When people ask me where I will start selling Euro or Australian dollar, or any other security I answer:”When more sellers will step in”. I do not have pre set targets for starting selling or buying when a level is reached. I might take profit at some point, but it does not mean I will start actively buying or selling. Why? Why should I if I do not see big boys changing the course? If the price is constantly rising you should not think about being bearish. The demand for security is still great. So why sell? Don’t. If you do you will only freeze your capital and wait impatiently for prices to reverse. It might happen soon, but if you start selling without any signs of reversal in supply and demand you are merely gambling, not investing. This is how lots of fund managers lost billions. They trusted too much their approach and predictions and became bearish or bullish too early. They started catching ‘falling knives’ and got hurt. Do not follow their example. Better train your eyes to see what dominates in the market: supply or demand and trade accordingly. You also have to wait and learn to see when supply gives way to demand and vice versa.

Support and resistance versus supply and demand 

Some people like watching support and resistance areas instead. It is ok, but not enough. These merely indicate what happened some time ago. Conditions might have changed and these areas may no longer be valid. Take as an example eur/usd pair. If you study daily charts you will see that according to classical technical analysis definition 1.3000 was a strong resistance. If you were going long in eur/usd it might have been a good level for you to exit your longs and have nice profit. On the other hand, it does not mean you have to start selling there. Why? Like I said, conditions might have changed and this area might not be resistance now. Taking into account the statement of FED that they are planning to keep interest rates as low as they are now till 2015 you might have more bullishness in Euro and much bearishness in US dollar in the nearest future. You see how the price pierced through 1.3000 level without stopping. What about our classical technical analysis rules: support becomes resistance? Well, it sometimes works, it sometimes doesn’t. You have to learn to follow price action and see the actual (current) levels of change between supply and demand and only then become a bull or a bear.  

How do you see that?

If a price is in a free fall you should not start buying. What you have to wait for is significant bounces that stop prices from falling further. It happens that when prices break through some level and we have very strong move (up or down). It is pointless to resist the move by going in the opposite direction. Better stay with the move. However, as time goes one you start seeing rallies against a prevailing move. If the price has been falling you suddenly see strong buying coming at certain levels. Do not mistake those with taking of profits. No. You have to watch how these happen. Long bullish candles would indicate that buyers start coming in. A lot of small candles would mostly mean that there has been some profit taking and this will definitely not stop prices from falling. 

However, one bullish move up will probably not change the direction so fast. Sellers will again step in and prices will resume their fall. However, with the next low formed you will probably notice more buyers coming in. Prices will run up again. Sellers will probably step in again, but this time there will be fewer of them. Depending on the strength of the downward move and inertia the process can continue for some more time till you will start seeing higher highs and higher lows. This would be a sign that demand is bigger now than supply and bulls have taken over control from bears. 

The important point here is how the price leaves certain area when the prices are still going down. You want to see big (really big bullish candles), not a cluster of small ones. Time comes and you start seeing these candles. Price suddenly rallies upwards. These are first signs of buying. It does not mean the bearish trend is over. You want to see more. After some time you see more of these candles. And more….! And finally bulls take over control from bears and prices explode upwards. (Look at gbp/jpy example below)

You can also look at the examples below (eur/usd pair) how bulls try to resist bearish trend and finally win. However, when you see a bearish trend you have to be on the selling side, not on the buying. You can see in the first chart how Euro bulls try to stand up, but they are standing only on one leg. I want to see a security standing on both legs before start real buying. That’s what happens in the second chart. 

Applying this supply and demand idea in practice

At the end of a major move you will probably see a lot of bears and bulls in one place. Finally the shift of power will take place. What you really want to do is to start playing from bull’s side if the trend is becoming bullish and from the bear’s side if the trend is becoming bearish. 

If we take example with eur/usd in the second chart (look up) you see how accumulation takes place in the pair. Bulls coming in with a lot of buying pressure causing bears to resist or simply close their positions. The price for some time is still in horizontal trajectory with very small upward direction. That’s when you have to start buying, because at some point pressure upwards will become so strong that the price will simply shoot up very fast and it will be not very logical to start buying there. 

So, when you see prices coming down to the place where buying takes place start buying and placing your stop orders below the most recent lows. Take a few orders, close one at the previous high and keep the other one open. Accumulate your position and go up with the price till you start seeing the shift of power again. Then reverse the process.

Ok, I hope the article was useful. I will surely expand the topic soon with more examples and more ideas from most recent trends in the market. Good luck. 

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Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.