Cause and effect analysis is one of the oldest ways to analyse What causes prices to move? If you understand the cause then only it will be easier to understand the reality of the stock market. Supply and Demand is the main cause why the share market moves up and down.
Professional technical analysts suggest that a better way to trade is to understand the cause of price movement.
Understanding the cause of price movement allows you to;
- identify potential moves before or as they occur;
- enter a price move earlier;
- understand why a price move is occurring; and
- assess when a move is likely to continue and when it’s likely to end.
The price move is the effect. Technical analysts try to understand the cause that might have an impact on the price move.
Before getting into how supply and demand moves the price up and down, we will discuss what is price and how it works in the stock market.
What is price in the stock market
Price is the amount a buyer pays to acquire stocks, futures, forex, or any other product from a seller on the stock exchange.
Understanding why prices move, will help you in understanding the nature of the market.
Any one transaction in the stock market, involves a product, and two parties – the buyer and the seller.
Before a transaction takes place, the seller is the owner of the product and the buyer wants to purchase it. Price is the amount that both buyer and seller agree upon for the transfer of the product from the seller to the buyer.
A trade in the market will take place when both buyer and seller agree at a price.
Price is the amount at which they both agree to transact. This means, price is the amount at which two traders make a buy and sell decision.
Market doesn’t wait for one transaction to take place before moving to another. They move based on how many traders in the market are making their buying and selling decisions.
These decisions make prices move. Price moves as a result of the net effect of all market participants making individual trade decisions.
Prices move based on the market participants’ opinion about the market direction. Prices don’t move due to technical indicators.
Market participants’ opinion is defined as bullish or bearish. If the sum of all the buy or sell decisions is bullish, then prices will go up. On the other hand, if it’s bearish, then prices will fall.
Supply and Demand concept – How does the price move?
Prices moved on the basic economic principle of supply and demand. This means, price movement in stock, future and options, forex, commodities or in any other financial market is a function of supply and demand.
Supply is the price of a product at which sellers want to sell.
Demand is the price of a product at which buyers want to buy.
Price of a stock or any other financial product will move with changes in the underlying supply and/or demand. If there is no supply and/or demand, the price will not move.
When demand of a financial security is greater than its supply, prices will rise to meet this demand, and conversely when supply of the financial security is greater than the demand then prices will fall, with the oversupply being absorbed as a result.
For example, suppose you want to buy stock of X at Rs 100, but someone wants to sell it at Rs. 105. Can a transaction occur?
No. The only way a transaction can occur is both buyer and seller must agree at a price.
In this case, a transaction will occur only if you accept the offer of Rs 105 or the seller will accept your offer of Rs 100. Another possible way is that you both have agreed at a different price in order to execute the transaction.
What happens when another buyer comes to market to offer a higher price of Rs 110. In this case, the seller will prefer to go for Rs 110 instead of accepting your offer of Rs 105/100.
Now you must be asking, why another buyer will offer a higher price. The simple reason is that he must be desperate to get the stock at whatever price available in the stock market, even at a higher price.
There can be any reason for such a high demand. In this case, the buyer is more desperate than the seller due to which he offered a higher price.
When buyers are more desperate than sellers, they offer higher prices or accept the offers of sellers. When supply gets absorbed to high demand, buyers will be forced to bid even higher to get their demand filled. In this way the prices continue to rally till they get buyers willing to pay higher prices.
The rally will stop after a point where buyers will not be willing to pay higher prices. Bulls who bought earlier will now be interested to book profit in order to close their transaction. When they do not get higher prices, they will be forced to lower prices in order to sell their shares. Now prices will fall.
Now sellers will be desperate to sell their transactions at lower prices as they are not getting buyers at a higher price.
By seeing fall in prices, some buyers will even offer lower prices to buy the stock. This will add more pressure on the supply side to offer lower prices to get their order filled.
In this way prices will continue to fall until we run out of supply or we get enough new buyers to absorb the supply.
In this way the whole process will start all over again.
Here are factors that can highly impact the demand and supply of a stock;
- economic data,
- terrorist attack and war,
- natural disaster,
- change in interest rates and central bank monetary policies, and
- corporations’ profits, sales, margins, and outlook.
Market is a dual auction process in which the ups and downs will be defined by the dominant force of buyer and sellers. If the buyers are more powerful than sellers, then prices will go higher. On the other hand, if sellers are more powerful than buyers then the market will go down.
In the market, you will never find prices moving in a straight line. They will fluctuate constantly in all the time frames you use due to the collective sentiment of buyers and sellers. Supply and demand will change constantly depending on the sentiment of the crowd.
Disclaimer:- In addition to the disclaimer below, please note, this article is not intended to provide investing or trading advice. Trading in the stock market and in other securities entails varying degrees of risk, and can result in loss of capital. Most investors and traders lose money. Readers seeking to engage in trading and/or investing should seek out extensive education on the topic and help of professionals.
