*Explaining the laws of supply and demand how they influence market prices*
Welcome back to the blog. In this blog post I am going to be explain to you economic principles of supply and demand and how they effect the financial markets you are trading. This is the 5th post in my “Market Dynamics” series of blog posts and you can find my most recent post by clicking on the link below.
What is supply and demand?
Supply and demand is the economic principle of price determination within a market. The idea of the supply and demand principle is that, so long as all else is assumed equal (quality, competition, ease of purchase etc.) the price of an asset or security will vary until settled at a point where the quantity demand equals the quantity supplied.
This can be represented by a simple supply and demand chart consisting of 2 axis (Price and Quantity sold) and 2 plotted lines (Supply level and Demand level).
The chart above shows the most simple of supply and demand graphs. It is considered simple because both the supply and demand lines plotted are non-exponential and perfect linear when in reality this is not the case. On the chart above, you can see that the current market price (equilibrium price) is where the current supply levels and current demand levels meet at a common price.
However, due to the nature of production and consumer confidence and marketing, price and supply is usually exponential and this therefore makes the influence of supply and demand, on market price, much more complex. The chart below shows a more realistic supply and demand chart.
What are the effects of supply and demand movements on price?
The main point of me wiring this blog post is to explain to you supply and demand and how they effect market price. This is because price is what we trade, the future price of an asset or security or good or service is what determines our profit or loss.
Let’s look at the main scenarios for changes in supply and demand and the effects on price.
|Demand Remains Constant||Demand Increase||Demand Decrease|
|Supply Increase||Price Decrease||No Movement In Price||Price Decrease|
|Supply Decrease||Price Increase||Price Increase||No Movement In Price|
|Supply Remains Constant||No Movement In Price||Price Increase||Price Decrease|
The table above shows the effects on price of changes in supply and demand. Don’t worry if you do not understand why these changes in price are caused because later in this blog post I will use finical market examples to explain why supply and demand might change and why this will effect price.
The charts below show changes in demand and supply and price in a visual format.
So far, all I have explained to you is simple economic theory and how supply and demand effects price but I have not referenced it to the financial markets. In the following sections of this blog post I will explain how the demand, supply and subsequently the price of various financial instruments are effected in the real world.
Supply changes in FX currencies.
The supply of a currency directly impacts its market equilibrium price and this is evident in the markets both in the short term and long term. The main influencer on the supply of a currency is Quantitive Easing (QE) carried out by the central bank of that economy.
QE is a form of monetary policy used to inject money directly into an economy and is done by the central bank creating new digital money and using it to buy government and corporate debt. This is done to boost spending and investment in the economy but a side effect of this is increased supply.
If you look at chart 1 shown above then you will see that if supply increases but demand stays the same, then price decreases.
QE and changes in money supply tends not to happen overnight but instead central banks create a plan for long term QE where they begin to create new money flows in to the economy over time to avoid short term price swings and extreme volatility. A rare instance of this not happening was during the first months of coronavirus pandemic in 2020 where central banks all announced plans for immediate QE and increased money supply in order to fight the effects of the impending recession. This then lead to a devaluing of many global currencies.
You can find data for the money supply of major currencies online at Trading Economics website.
Demand changes in FX currencies.
Demand for a currency is ever changing and is primarily driven by the demand for a country’s exports. If there is increased demand for exports of goods and services then demand for that countries currency will increase because it is needed for currency exchange in order to make payment. Speculators of currencies (traders and investors) are also responsible for demand changes, if they believe the value of a currency will likely increase in the future then they will look to buy that currency and this in turn creates more demand.
A central banks fiscal policy can also have effects on the levels of demand for a currency. If a central bank decides to raise interest rates in order to control inflation then this can create short term demand increases for their country’s currency which is called “hot money”. Higher interest rates makes a country look more attractive for investors compared to those with lower rates, but in order to benefit of the higher interest rates, an investor must hold the currency of that country and therefore demand increases.
If you look at chart 3 shown above then you will see that if demand increases but supply stays the same, then price increases.
More often than not, changes in interest rates are forecast and planned and therefore priced in to the markets over time prior to the actual change and therefore price swings and volatile is avoided. However, there are instances where central banks will announce surprise interest rate changes and this can cause large short term changes in price.
The chart above shows the effects of a surprise interest rate cut from the Bank of England in March 2020. This lead to a large short term decrease in demand and therefore a large decrease in price.
Supply changes in Commodities.
Commodities are mostly influenced by supply and demand because in their standard form (excluding derivative financial instruments), they are grown or mined and are purchased to used and consumed.
- Hard Commodities are mined or extracted such as Crude Oil, Gold and rubber.
- Soft Commodities are grown or livestock such as wheat, coffee, soybeans and pork.
The supply of a commodity and therefore the price, can be effected by a great number of external influences. The supply of wheat in to the markets is often determined by the weather in regions where wheat is primarily farmed. This is because adverse weather can mean wheat is not grown or the quality is reduced and this in turn means there is lower supply when it is eventually sent to market, this will increase prices.
If you look at chart 2 shown above then you will see that if supply decreases but demand stays the same, then price increases.
Producers of commodities can also choose to cut production in order to decrease supply and maintain or control price. This is quite common in the Crude Oil markets where OPEC (Organization of the Petroleum Exporting Countries) looks to maintain steady prices for oil producers by monitoring and controlling production across the globe.
Remember, the only people who tend to favour huge levels of volatility are day traders because for businesses and institutions, volatility costs money.
Demand changes in Commodities.
Much like supply, demand for Commodities is influenced by external fundamental factors, specifically seasons. For example, natural gas is extremely cyclical especially when looked at per region because in summer people do not have their central heating on in their homes but in winter they do. The seasons therefore dictate the biggest changes in demand for commodities like natural gas and this therefore means price changes.
The image above shows the basic cycles of natural gas usage (demand).
The smart money and those who use a lot of natural gas (residential and commercial energy providers) will use futures contracts to hedge these cycles in order to maintain that they pay steady prices. You can learn more about futures contracts and their uses by reading my previous market dynamics blog post. Click on the link below to check it out.
An excellent example of how changes in demand effect the price of a commodity is to look at the crude oil crisis that occurred in April 2020 when short expiration futures actually went into negative prices.
With the coronavirus pandemic in full swing and global travel restrictions in place, large scale demand for crude oil dropped massively. Air travel dropped by around 90% at it’s peak and no cruises were going, individual were locked down at home so driving cars was limited. This huge decrease in demand lead to prices decreasing dramatically.
If you look at chart 4 shown above then you will see that if demand decreases but supply stays the same, then price decreases.
This was a short term drop in demand and not really justified but it shows an extreme version of the laws of supply and demand at work. The very next day, the same oil that was trading at -$35 per barrel was back trading at +$10 per barrel.
Supply and Demand changes in Stocks.
The supply of stocks is always changing. When a stock holder decides he wants to sell some shares on the open market, he will put out an order with his ask price and this then means the supply of that stock on the market has increased. If more sellers than buyers exist, price will go down because supply exceeds demand. The opposite can be said for “hot stocks” where more buyers exist than sellers and thus demand exceeds supply.
The supply of stocks on the market can also be increased through the actions of the company itself via rights issues and stock splits. This is where more shares of the company are issued so the existing share holding is diluted and therefore supply has increased.
A good example to use for how the supply of stocks effect price is to look at the stock split of major companies like Apple and Tesla who have both executed new stock splits this year. Back in June 2014, Apple stock split by a ratio of 7-1 which is visible on the chart below.
As you can see, when the stock split is executed the stock price tends to divide by the same number of shares that increase because although supply has increased, demand as stayed the same. However it is very common that this then increases demand in the longer term and price begins to rise because a much lower stock price means it is now accessible to more potential buyers. This is the main reason why companies execute stock splits.
If you look at chart 1 shown above then you will see that if supply increases but demand stays the same, then price decreases.
Demand for stocks comes from the various market participants including investors, speculators, banks and institutions. Almost all market participants buy stocks to make money because they are betting on the value of the stock increasing in the future. The main reason for demand increasing usually comes from a change in perception and view whether that is from potential increased revenues and/or profit margins rising which in turn will increase income for stock holders (via dividends).
If a certain industry is doing better like tech is right now, then tech stocks will see increased demand and therefore prices of tech stocks will rise. This has been proven this year with the likes of Tesla, Amazon and Microsoft all seeing their stock prices rise despite the coronavirus pandemic effecting all other areas of business.
Can price effect supply and demand?
Yes, if price is reduced then naturally an asset or security becomes available to greater number of potential buyers and this in turn increases demand. Much like a decrease in price might force a supply decrease from producers/suppliers because it may become less profitable or even not profitable to produce a commodity at the current price level. A decrease in supply will then in turn start to increase price as it looks to revert its way back to updated equilibrium.
This then becomes a cycle which is what you see in terms of price movements in the financial markets that continues day today day and year on year. The image below shows a basic flowchart I have sketched to show the cycles of price and supply and demand all effecting one another.
The laws of supply and demand are present in all markets wherever price movements occur and there are buyers and sellers of an asset, security, product or service. The main point I want you to take away from this blog post is how the changes in supply and demand, whether increased or decreased, effect price because that is what you trade.
When trading, you are trading the price of an FX currency, commodity or stock market index and if you are long a stock you then expect price to rise in order for you to make a profit. It is good to know how the outcome of various fundamental influences on supply and demand might effect the profitability of your open trade positions.
If you are interested in learning my personal trading strategies, please consider my Mastering The Markets – Retail Trading Course. Head over to my Trading Education page to check out all of my education packages and the deals available.
All my technical analysis is done using the TradingView platform. You can get access via the link below.
My preferred broker of choice is IC Markets. Low spreads and trading costs really help long term profitability. A link to their site is below.
FTMO Trader Funding Programme.
Thanks for reading and please don’t forget to LIKE, SHARE and FOLLOW my blog to stay up to date with the latest market analysis and trading education posts.
DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.