Supply and Demand

Do you really understand why the price shifts?

The law of supply and demand is one of the three basic laws that Richard Wyckoff introduced into financial markets.

This law governs all price changes, and is therefore the best indicator for future movements. It works in all markets and time frames.


Background to the law of supply and demand

oferta y demanda

Richard Wyckoff was the first to introduce this fundamental law of economics and he told us that if demand was greater than supply, the price of the product would rise; that if supply was greater than demand, the price of the product would fall; and that if supply and demand were in equilibrium, the price of the product would be maintained.

This idea is very general and should be nuanced because there is a very common error in thinking that prices go up because there are more buyers than sellers or that they go down because there are more sellers than buyers.

In the market there is always the same number of buyers and sellers; for someone to buy, there must be someone to sell to.

Theory

libro de órdenes
Ejemplo gráfico de un libro de órdenes

In the market there are buyers and sellers who interrelate to match their orders. According to auction theory, the market seeks to facilitate this exchange between buyers and sellers; and this is why volume (liquidity) attracts price.

The general accepted theory in economics tells us that supply is created by sellers by placing sales (pending) limit orders in the ASK column and demand is created by buyers by placing purchase limit orders in the IDB column.

There is a very common error in calling everything to do with the purchase demand and everything to do with the sale offer. Ideally, different terms should be used to distinguish between aggressive operators and passive operators.

The terms supply and demand correspond to taking a passive attitude by placing limit orders in the IDB and ASK columns.

While when an operator takes the initiative and goes to the IDB column to execute an aggressive (to market) order, he is known as a seller; and when he goes to the ASK column, he is known as a buyer.

All this is a mere formality and has more to do with theory in economics than with practice. The key to everything is in the types of orders that are executed. We must differentiate between market orders (aggressive) and limit orders (passive).

Passive orders represent only intention, they have the capacity to stop a movement; but not the capacity to make the price move. This requires initiative.

Price Shift

Initiativedesplazamiento del precio

In order for the price to move upwards, buyers have to buy all available sell (bid) orders at that price level and also continue to buy aggressively to force the price up one level and find new sellers there to trade with.

Passive buy orders cause the bearish movement to slow down, but on their own they cannot raise the price. The only orders that have the ability to move the price up are those purchases to market or those by whose crossing of orders becomes purchases to market.

Therefore, an upward movement of the price can be given by active entry of buyers or by executing Stop Loss of short positions.

For the price to move downwards, sellers have to purchase all available purchase orders (demand) at that price level and continue to push downward by forcing the price to search for buyers at lower levels.

Passive sell orders cause the bullish movement to slow down, but it does not have the ability to bring the price down on its own. The only orders that have the ability to move the price down are sales to market or those by whose crossing of orders becomes sales to market.

Therefore, a downward movement of the price can be given by active entry of sellers or by executing Stop Loss of long positions.

falta de interés

Lack of Interest

It is also necessary to understand that the absence of one of the two forces can facilitate price displacement. An absence of supply can facilitate the rise in price just as an absence of demand can facilitate its fall.

When the bid is withdrawn, this lack of interest will be represented as a smaller number of contracts placed in the ASK column and therefore the price will be able to move more easily upwards with very little buying power.

Conversely, if demand is withdrawn, it will result in a reduction in the contracts that buyers are willing to place with the IDB and this will cause the price to go down with very little selling initiative.

Conclusion

precio y volumen

Regardless of the origin of the purchase or sale order (trader retail, institutional, algorithm etc.) the result is that liquidity is added to the market; and this is what is really important when trading.

Two of the tools we can use to understand the result of this interaction between supply and demand are price and volume.

It is necessary to develop the ability to correctly interpret the price action with respect to its volume if we want to know at all times what is happening in the market.

This is why I consider the Wyckoff methodology to be a really solid approach when analyzing what is happening in the graph (accumulation and distribution processes) and making judicious scenarios.


Recommended Posts: The Law of Cause and Effect  – The Law of Effort and Result


The Wyckoff Methodology in DepthA clear and close text with which you will be able to learn all the elements of the Wyckoff methodology

Supply and Demand
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