Section 1:

Understanding Supply and Demand Dynamics

 

Fundamentals determine the price of a stock in the long run. It’s just that simple. Fundamentals consist quite simply of two components: profits and dividends. These two factors determine the price of a stock in the long run.

Over a three year period shares of Google (GOOG) went from $200 to over $700 as seen in Figure 1.1. Why? The company consistently increased its profits thanks to a brilliant business model, limited competition, and innovation.

 
Figure 1 .1

Over a two year period shares of Beazer Homes (BZH) cascaded from $80 to below $10 as seen in Figure 1.2. Why? The company’s profits plummeted as the U.S. housing market deflated and the subprime mortgage market imploded.

Figure 1 .2

Ultimately corporate profits (or losses) and dividends determine the price of a stock. But the expectations for profits and dividends vary second-by-second every trading day. The changes in expectations cause wild and potentially profitable swings in stock prices. You can see in the above examples that there were wild swings in both of these stocks, although the overall trends were well defined over several years.

The wild swings that frequently occur in stock prices are due to factors other than corporate profits and dividends. These other factors have a huge influence on stock prices over shorter periods of time. Factors such as the business cycle, politics, financial crises, the specter of war, new technologies, natural resource shortages or surpluses, and taxation, among innumerable others, frequently cause wild swings in stock prices. These factors have a huge impact on stock prices because they influence expectations for profits and dividends.

The ever-changing expectations for profits and dividends influence the demand for and supply of a stock. Expectations for future profits and dividends can change in an instant, or they can be erroneous in the first place. That’s because the decision making process when buying or selling stocks is influenced by human emotion. Fortunately human emotion is imperfect and inefficient, creating potentially profitable opportunities for traders skilled in identifying patterns.

The way to think about supply and demand in the market is in terms of sellers and buyers, respectively. The sellers are the source of supply and the buyers are the source of demand. Their collective action or inaction shapes the path of a stock price over shorter periods of time such as hours, days, weeks, or months.

There are two types of buyers and two types of sellers. Understanding these different trader types and their motivations will lay the foundation for trading price patterns.

Long Buyers

Long buyers purchase a stock in the expectation that the stock will go higher over time. Put another way, long buyers buy a stock to make money. Long buyers might know something that the rest of the market doesn’t, have a favorable opinion about the future of the economy, or think that a company is going to report increasing profits, to name just a few reasons.

Long buyers might plan to hold the stock for a few hours or several years, and every timeframe in between.

Long buyers have a tremendous tailwind working in their favor. It’s the upward drift in stock prices. Stocks tend to go higher over time, which is why it makes sense to trade with an overall long bias.

Long buyers enjoy an additional benefit in the risk and reward trade off. Long buyers enjoy an unlimited profit potential because there’s no limit to how high a stock can go. The maximum loss that a long buyer might suffer is defined by investment into the position. A stock can go only as low as zero.

Long Sellers

Long sellers were once long buyers. They sell either to take profits or take losses. Human emotion plays into the selling decision or indecision much more than the decision to buy.

Long sellers might be motivated to sell by the fear of losing a profit. Or they might sell after they have lost all hope of a recovery and a stock has dropped well into losing territory.

Short Sellers

Short sellers sell a stock that they don’t own in the expectation that the stock will go lower. Short sellers do so by borrowing stock on the promise they will return the stock to its owner at a later date. The short seller hopes to do so at a much lower price, pocketing the difference.

Short sellers typically have a shorter time horizon, relying on a catalyst to cause a stock to drop.

Short sellers are arguably the smartest group of traders because they have to be. Short sellers have to fight the upward drift in stock prices. It’s a tremendously powerful tide to go against.

Short sellers might be motivated to sell a stock short based on increasing competition within an industry, fraud, deteriorating economic conditions, or a hike in interest rates by the Federal Reserve, to name just few.

The maximum profit a short seller can make is achieved if a stock goes to zero. The maximum loss a short seller might incur is unlimited.

Short Buyers

Eventually short sellers must buy back, or cover, their short position. This turns a short seller into a short buyer.

Understanding Supply and Demand Dynamics Summary

The fundamentals ultimately determine the price of a stock. But this fact is only relevant when considering stock prices over long periods of time. Stock prices are inefficient and seemingly random over shorter periods of time due to the changing forces of supply and demand. The forces of supply and demand are inefficient and seemingly random due to the human element.

The supply of and demand for a stock are constantly changing. Buy and sell orders rapidly determine the price of a stock over seconds, minutes, and hours. But the levels of supply and demand can be aggregated into trends. These trends take shape over days, weeks, and months. These trends can be defined in a consistent and objective way, which quantifies the supply and demand situation for a stock.

Understanding the forces that shape trends is a critical component of trading price patterns. It’s necessary to define trends, and changes in trends, in order to apply price patterns. Identifying trends is the focus of the next section.