What are Supply and Demand Zones in the Stock Market?
Learn what supply and demand means in the market and how can you utilize these to improve your trading.
As the market continues to make new highs and test investors’ tolerances for volatility, the terms supply and demand have been thrown around increasingly more. You may be familiar with what supply and demand is in a business sense, but what exactly do these terms mean in the market and how can you utilize these to improve your trading? The answer is: supply and demand zones. This is a tool you can use to help make your stock market predictions for 2020.
In business excess supply means a manufacturer or company produced more of a product than what the market is willing to or able to buy. This surplus typically leads to a decline in prices as the business tries to sell more of a product to a wider audience. When supply declines, price increases as the company meets the equilibrium price where maximum profit is achieved in the balance between supply and demand. This balancing act is very similar in the stock market and can be observe in the Level II data of a stock symbol. The Level II is a table that shows how many shares at a certain price are on the bid and the ask. The bidding price is where the next buyer is looking to purchase shares of the stock. The asking price is where the next seller is looking to sell shares of the stock. When there is excess supply in the market, you will see more shares on the ask than the bid. This imbalance implies there is a bearish preference at the current price point and that the price is above the equilibrium price.
An edge in the market is where you capitalize on the swings above and below the equilibrium price. If you can get a feel for this imbalance, you can trade with an edge, which is where you sell to an excess of greedy buyers or buy from an excess fearful sellers.
Just as supply is an excess of product in the business world, excess demand is when there are more customers looking to purchase a product than there is product available to sell. Excess demand leads to a raise in prices as the company tries to make up for not selling enough product — again, trying to meet the equilibrium price of maximum profit. In the stock market, excess demand occurs when investors and traders have bullish mindset and try to buy shares from a market that doesn’t have enough to sell. In this case, you see a stock spike up as buyers get in at higher and higher prices.
When comparing supply and demand in the market to the business world, you have to keep in mind that the market is unbiased and factors is the effects of deindividuation. Deindividuation in the market is when a trader or investor forgets they are acting as a lone wolf in a system that functions off of a group mentality. The market swings in the direction of the group, however, each individual trader is making decisions behind a desk without any other external factors swaying their decisions. When you trade an edge in the market, you are the individual betting on the biases of the group (with or against the trend). To avoid the negative effects of deindividuation as a trader, you must remember the market is simply a stream of information and you are an individual picking patterns and trends out of that stream based on your own personal lenses.
How to Use Supply and Demand in Your Trades
Are you familiar with levels of horizontal support and resistance? These are price levels where a stock price struggles to break through. Support is a level below the current price of a stock that “holds” the stock up. Resistance is a level above the current price of a stock that “pushes” the stock down. You may see candles on a chart bounce off of a specific price three ortimes. This reliability implies a strong level of support or resistance. Supply and demand works in a similar way. Resistance levels offer increased supply as sellers take control of the market and turn the stock price down. Support levels offer increased demand as buyers take control of the market and turn the stock price up. The difference between these types of invisible barriers is that horizontal S/R are drawn as lines and Supply/Demand are drawn as zones. Let’s use this chart as a demonstration:
Here is the chart with horizontal support and resistance lines drawn in:
Notice how resistance levels turn into support in this bullish chart. This transition is why these levels are called S/R. They are both support AND resistance depending on whether the stock price is above or below these levels.
Here is the same chart with supply and demand zones drawn in:
You can see a similar swap happens with supply and demand, but it isn't as clear or direct. This is because zones where investors and traders buy and sell have technical, fundamental, and psychological reasons behind purchasing or selling. When a stock price transitions through an area of supply, the buyers regain control at that level. In order to do this, there must be more buyers than sellers, causing the stock price to increase. Because there are now more buyers in this zone than sellers, there is more demand than supply and this zone becomes an area of excess demand.
Now that you see the zones of supply and demand, you can start to visualize where your edge would be. Each arrow below represents an edge:
Do you spot the zone where there is no edge?
The candles in the circle are in equilibrium. The trend of $AAPL does not have a bullish or bearish preference. Neither buyers or sellers are winning. There is no edge. The stock is trending sideways. If you were to buy or sell in this area, you would be gambling 50/50 odds like flipping a coin. Don't bet your money on a coin flip — wait until you have an edge!
Supply and demand zones are price ranges where a stock has a surplus of shares available for sale on the ask (supply) or an excess of share attempted to be bought on the bid (demand). When the supply and demand zones meet, this is called the equilibrium price (see Equilibrium in Apple Stock image above). At this level, both buyers and sellers agree to the price with equal numbers of shares available on the ask and the bid (see "Level II"). You can assume a stock will be supported by a demand zone from above and resisted by a supply zone from below. To gain an edge (see "Edge") as a trader or investor, you bet on the direction of a stock's supply and demand based on the probability of a stock moving with or against the trend (see Edge in Apple Stock image above). Always make sure your trade plan has a good Reward:Risk ratio before executing your trade.
Glossary of Terms
The Market - the collection of stock exchanges where buyers and sellers exchange shares of publicly traded stocks.
Supply - the total quantity of a good or service a seller is willing to provide at the prevailing price during a defined period of time.
Demand - the total quantity of a good or service a buyer is willing purchase at the prevailing price during a defined period of time.
Bid - the highest price a buyer is willing to pay for a share of a given stock.
Ask - the lowest price a seller is willing to accept for a share of a given stock.
Level II - a real-time order list that displays the best ask and bid prices for each of the exchanges making markets in stocks, options, and futures.
Edge - the probability advantage of a stock trader or investor purchasing or selling shares of a stock based on the market trend.
Equilibrium price - the market price where the quantity of shares supplied is equal to the quantity of shares demanded.
Deindividuation - the loss of self-awareness in a group setting.
Biases - to feel or show inclination or prejudice for or against the trend of a stock.
Support - a price level where a stock tends to bounce off of when declining.
Resistance - a price level where a stock tends to bounce off of when inclining.
Candles - a measure of price over a designated period of time on a candlestick chart showing the opening, closing, high, and low prices.
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