Supply & Demand: Definition and Importance in Trading

Supply and demand are among the fundamental dynamics of the economy and finance. As one of the most essential concepts for understanding how markets function, the price of any good or service in the market is shaped by the balance of supply and demand. They not only determine the prices of goods and services but also influence production quantities, trade volumes, and even economic relations between countries.

This balance is directly related to how much buyers demand and how much sellers supply. When demand increases and supply remains constant, prices are expected to rise; conversely, if supply increases while demand remains constant, prices may tend to decrease. This simple equation generally holds true in trading operations as well.

What are Supply and Demand?

Supply refers to the quantity of a particular asset made available in the market. High supply indicates that there are numerous sell orders at a specific price level, signaling that strong demand is required to surpass this level.

For example, in the forex market, the supply of a particular currency can increase or decrease depending on various factors such as central bank monetary policies, interest rates, and foreign exchange reserves. A country's central bank may increase currency supply by printing more money or selling foreign exchange reserves, which can lead to a decrease in the currency's value.

Traders analyze supply levels to make predictions about the direction of an asset's price movement. For instance, if a trader notices that a currency pair is approaching a resistance level where supply is concentrated, they might consider that it could be difficult for prices to break through this level and might anticipate a potential pullback.

Demand, on the other hand, refers to the desire and buying power to purchase an asset at a specific price level in financial markets. High demand is interpreted as a significant number of buy orders at a certain price level.

For example, if a trader observes that a currency pair is approaching a support level with high demand, they may assess the possibility of prices bouncing upwards from this level.

How Does Supply and Demand Affect Markets?

Prices in markets are shaped by the balance between supply and demand. When the supply of an asset exceeds its demand, meaning that there is an abundance of the asset in the market while demand remains low, prices generally tend to decrease. This is because sellers may have to lower prices to attract buyers due to insufficient demand.

Conversely, when demand exceeds supply, meaning that there is high interest in a particular asset and supply is limited, prices tend to rise. In this scenario, buyers may be willing to pay higher prices to acquire the limited asset.

In dynamic markets like Forex, the balance of supply and demand is a critical factor for understanding short-term price movements. Central bank policies, economic data, and global events are external factors that can impact supply and demand, leading to sudden changes in currency exchange rates.

Additionally, supply and demand play a significant role in determining the overall trends in markets. In the long term, a strong increase in demand can lead to a continuous rise in the value of an asset, while consistently high supply can cause a lasting decline in an asset's value.

Factors That Shift the Supply and Demand

The main factors affecting supply can be summarized as follows:

• Monetary policies aimed at increasing or decreasing money supply directly affect the supply of currency.
• High interest rates can increase the attractiveness of a local currency, thereby reducing its supply. Investors may be drawn to that currency for higher returns, leading to a decrease in supply.
• Geopolitical factors such as wars, political crises, and trade disputes can limit or increase the supply of certain assets.
• Economic indicators such as unemployment rates and inflation data can impact the supply side of markets. Negative data can cause investors to shy away from risky assets, leading to a contraction in supply.

The factors affecting demand are as follows:

• The general sentiment of market participants (e.g., bullish or bearish market expectations) greatly influences demand. Optimistic market sentiment can increase demand, while pessimistic sentiment can decrease it.
• The amount of liquidity in the financial markets is a key factor influencing demand. High liquidity allows more investors to enter the market, leading to an increase in demand.
• Global economic developments such as economic growth or recession can cause demand to rise or fall.
• Investors' willingness to take risks is also a factor affecting demand. High risk appetite can increase demand for riskier assets, driven by the expectation of higher returns.

What Happens When Supply is Higher Than Demand?

When supply is higher than demand, prices in the market generally tend to decline. This situation means that sellers must compete more aggressively to sell their assets because the supply of assets in the market is sufficient to meet the demand.

Excess supply forces sellers to lower prices, as buyers leverage the surplus to negotiate lower offers, using the pressure on sellers who are eager to offload their assets.

Sometimes, excess supply can lead to sudden and sharp declines in the markets. Such scenarios may increase the tendency of investors to exit the market, which can further drive prices down. Additionally, in situations of high supply and low demand, liquidity can decrease, making it more difficult to execute trades in the market.

What Happens When Demand is Higher Than Supply?

In a market where supply exceeds demand, prices often tend to increase. Because there are more bidders vying for fewer assets, buyers are compelled to make greater offers. As a result, this may cause prices to rise quickly. These price hikes become more noticeable, particularly when supply is constrained and demand is high.

Demand-over-supply situations usually cause asset values to rise quickly, luring investors to purchase at greater prices. High demand and low supply can also improve market liquidity, which facilitates quicker and easier transaction execution.

How to Spot Supply and Demand Zones on Charts

Supply and demand zones are specific levels where prices typically react. Supply zones are levels where prices often pause or reverse as they move downward from a higher level. These are areas where sellers exert pressure on the market, causing prices to decline. They are generally found near resistance levels.

Demand zones, on the other hand, are levels where prices often pause or begin to rise as they move upward from a lower level. These zones are usually located near support levels and indicate where buyers are entering the market.

Need more information about support and resistance? Please check the relevant article.

FAQs on Supply & Demand

How to identify supply and demand zones in Forex?

To identify supply and demand zones, first, you need to determine the price levels where significant reactions have occurred in the past. Supply zones are areas where the price has stalled or reversed when moving downward from above. Demand zones, on the other hand, are levels where the price finds support and starts to rise when moving upward from below. These zones typically manifest as prominent peaks and troughs on the chart.

When does an excess supply lead to a price decline?

Excess supply leads to a price decline when the demand for a particular asset is low while the supply is high. In such a situation, sellers must compete to sell their assets, while the number of buyers remains limited. Sellers are forced to lower their prices to attract buyers, leading to a general downward movement in market prices.

How is supply and demand analysis used in trading strategies?

Traders shape their trading strategies by selling at supply zones and buying at demand zones. Supply-demand analysis helps predict future market movements and allows traders to manage their risks. Since supply and demand zones are considered levels where prices are likely to react, they are also used to determine stop-loss and take-profit points.

How is the supply-demand balance disrupted?

The supply-demand balance can be disrupted by changes in market conditions, central bank policies, economic data, geopolitical events, or market sentiment. For instance, a factor that increases supply can cause prices to fall, even if demand remains constant. Similarly, a sudden increase in demand can drive prices up quickly if the supply remains steady. Such imbalances can lead to sharp and sudden price movements in the markets.

How are supply and demand zones drawn?

Supply and demand zones are typically drawn at levels where prices have shown significant reactions. To identify a supply zone, you look for an area where the price peaked and then quickly declined. For a demand zone, you look for an area where the price dipped and then showed a strong rise. These zones are marked on the chart to monitor how prices may react to these levels in the future.

How is trend following done with supply and demand analysis?

To determine whether a trend will continue or reverse, attention should be paid to the supply and demand zones. For example, in an uptrend, if demand zones are consistently tested and held, it indicates the trend is strong. However, if supply zones are frequently tested and prices pull back from these areas, it may suggest the trend is weakening and a potential trend reversal is approaching.

What are the most common mistakes in supply and demand analysis?

One of the most common mistakes in supply and demand interpretation is incorrectly identifying these zones. Mistaking random price movements for supply or demand zones can lead to misleading signals. Additionally, relying solely on supply-demand without considering other technical analysis indicators can be risky.