Supply and Demand

Price has a memory and I am going to give you an exaggerated example of something most of you should be able to relate to. Let’s imagine going to the gas station one week where you fill the tank at a price of 2.89 a gallon. A week later you go back to the same gas station and the price per gallon is now 3.15. Instead of filling the tank you decide to fill it half way since it was just 2.89 a week ago. A few days later you go back and the price is now 3.50 a gallon. This time you fill the tank because you are afraid the price is going to be even higher the next time you need gas. You go back a week later and just as you feared the price is over 4 dollars a gallon. Do you fill the tank or only put in a half tank? The highest price you have ever seen on gas is 4.50 a gallon and last time you filled up at that price it went down 20 cents a week later so you decide to just put in just a half tank. As you are driving around you are paying attention to the price other gas stations are charging making a mental note of a station that is selling gas cheaper than what you have been paying for it you may even start going there for gas. When prices get to high you start contemplating carpooling, taking the bus or riding your bike to work. Your memory of price impacts your actions and your actions are impacting supply and demand. If enough people start taking the same action the price will react accordingly.

Stocks prices have memory as well and there are areas of supply that need to be absorbed before they can continue to move in either direction. Let’s say you buy a stock at 5 dollars and the price drops dramatically. It goes down to its former low which was firm support in the past. It eventually breaks through that support after soaking up the supply of stock that people bought when they thought it was too cheap to resist. Once that level of support is broken it now becomes resistance on the way back up. The stock tumbles to new lows and builds a base. Eventually it begins to rise and that previous low serves as a ceiling because people that have been holding on through the correction are now trying to unload their supply just so they can break even. Not until that supply is absorbed can the price continue to climb. If that supply gets absorbed it may climb back up to your 5 dollar entry and if it does what are you going to do? Barring any significant news that would lead you to believe it’s going much higher, you are likely to try and exit the trade so you can break even which creates more supply. There are technical areas like moving averages that will also act as supply zones. These areas of former price support and resistance, as well as technical indicators, can help determine where there are areas of supply are and what our risk reward potential is before establishing a new position.

Example    

 

Each time an area of resistance or support is challenged or tapped supply gets absorbed which increases the odds of the stock being able to move on to its next area of support or resistance.

Imagine there are tiered bowls of water, you take a sponge and dip it in the bottom bowl of water. Each time you do this the water is absorbed until there is nothing left. There is no more supply to be absorbed which allows you to move up to the next bowl and start absorbing the water there.

The bowls represent supply, bigger bowl more supply, smaller bowl less supply. The sponge or a wet vacuum represents demand, bigger the sponge or more powerful wet vac means quicker absorption. The water represents the float, how much water is available will impact how long the water can be supplied. While the spigot represents the volume of water coming in. The tier levels represent price.

Now imagine the spigot over the top bowl controlling the volume of water flow. Open the spigot up too much and eventually the bowl can’t hold all the water and begins to overflow to a lower level of support where it will pool up until it can find an even lower level. If the spigot is wide open, the bowls and the sponge simply won’t work because the volume it too much for them to handle and it eventually creates a waterfall sending the price to a lower level rapidly. Turn the spigot off or to a slow drip and you can start absorbing all the water in the lowest bowl until nothing remains. If you want more water you have to start getting it from the next higher bowl which comes with a higher price. Absorbing a full bowl of water takes time and it is a slower process than when the spigot is wide open and overflowing the bowls but eventually you will absorb all the water with a sponge.

If the well runs dry you will have no choice but to start getting your water from the bowls which limits the supply and drives the price even higher as demand is outpaces supply. This is when you break out the wet vac to soak up as much supply as fast as you can before the water is all gone and you have to start importing it from another well.

 

This example should give you a good visual of how supply and demand combined with float and volume determines the price.

These areas of support and resistance exist in all time frames and if you can align them it gives you a more powerful setup.

Mass psychology of the markets is the spigot that controls the water flow. If the majority of the market is in a panic then the spigot is wide open flooding the market with too much supply. If the majority of the market is thinking that there is a drought and water is running out then they break out the shop vac and start sucking up supply hoarding as much as they can. Without the masses there would be no supply and demand.

It’s critical that you recognize what the majority is thinking so you can participate in the early stages of a psychological transition in markets or stock since this is when the bulk of your profits will be made. As the psychology becomes more balanced the profits are harder to come by, stocks base out in a tight range waiting for the next catalyst to determine the direction of its next move. This can be considered “choppy action” meaning there is no clear direction of the masses or market psychology.

Day traders are looking for stocks where the psychology of the masses is about to change and hit extreme levels on much shorter time frames like the one, three or five minute charts using the 15, 30 minute and possibly the daily charts for multiple time frame alignment. Time frames will vary based on personal preference.

Figure 1 Daily 30 minute and 5 minute cart

While swing traders and longer term investors will use monthly weekly and daily time frames on their charts.

Figure 2 Monthly, Weekly and Daily Charts

It should be noted that the longer time frame is considered the DOMINANT time frame. For example while a stock will have mini patterns develop in shorter time frames the dominant trend is the trend established by the longer term time frame. Let’s use PDFS to illustrate this example.

Figure 3:  Weekly chart with dominant trend line

Figure 4:  Daily chart with weekly dominant trend line

Figure 5: 4 Hour chart with weekly dominant trend

Notice how in each time frame there are mini trends that form and different types of patterns develop that technical traders look for. A strong indicator to look for to confirm trend is higher highs and higher lows in an uptrend and lower highs and lower lows in a downtrend.  The charts get more erratic and develop more patterns as the window of time gets shorter. Yet the overall dominant trend remains intact. The time frame you are trading in can look significantly different than a longer term time frame, taking a step back and looking at a longer term time frame can help you identify the dominant trend. Having alignment on multiple time frames will give you more confidence that your strategy is a sound one and help identify ideal entry and exit points. Paying attention to the volume will give you an indication of what the mass psychology is and how likely it is for the dominant trend to continue.

Figure 6: Weekly break in dominant trend

 

Figure 7: Daily dominant trend break

Identifying what phase of a cycle the market is in will also help you determine how serious a long term trend break is for individual stocks. If the market is beginning its distribution phase it is likely that the trend break will intensify once the mark down phase begins since 90 percent of stocks are going to follow the overall markets lead. This is where shorts are likely to become more aggressive. Shorts will wait for confirmation of the trend line break and an increase in selling volume supported by a weak market to build on their short positions. When price bounces up into resistance like moving averages or former price support on low volume the shorts add to their positions setting a stop loss just above the resistance point.