The meaning of demand and supply and their application in investing

If you’ve ever wondered why stock or commodity prices go up or down, the answer often relates to the concepts of supply and demand. These two fundamental ideas are not only the foundation of economics but also essential tools investors use to predict market movements.

Supply and Demand: Basic Understanding

Simply put, supply and demand reflect the desire to buy and sell in the market. These two factors work together to determine the actual prices in real life.

Demand is the desire to purchase goods or services at various price levels. Analyzing this data produces a Demand Curve, which shows the relationship between price and the quantity consumers are willing to buy. Each point on this curve indicates how much consumers are willing to purchase at a specific price or the maximum price they are willing to pay for a given quantity.

Supply is the willingness to sell goods or services at different prices. When plotted as a graph, it creates a Supply Curve, showing the quantity sellers are willing to offer at various prices. It also indicates the minimum price at which sellers are willing to sell a certain quantity.

The Law of Demand and Factors Affecting It

Law of Demand states that there is an inverse relationship between price and quantity demanded: as price increases, demand decreases; as price decreases, demand increases.

This phenomenon occurs due to two main reasons:

Income Effect — When prices fall, the real value of your money increases (you have more purchasing power), allowing you to buy more.

Substitution Effect — When prices change, you compare the good to similar alternatives. For example, if Good A’s price drops but Good B remains expensive, you might buy more of Good A instead.

Besides price, other factors influence demand:

• Consumer income
• Prices of related goods
• Tastes and preferences
• Number of buyers in the market
• Expectations about future prices
• Seasons and new technologies that create new demand

The Law of Supply and Factors Influencing It

Law of Supply states that there is a direct relationship: as prices rise, sellers are willing to supply more; as prices fall, supply decreases.

Factors affecting supply include:

• Production costs (materials, labor, energy)
• Prices of substitute goods that producers can make
• Technology improvements
• Number of competitors in the market
• Future price expectations
• Weather and natural disasters
• Tax policies and access to capital

Equilibrium Point: Where Buyers and Sellers Meet

If only buying or selling pressure existed, prices wouldn’t be determined. In reality, prices settle at the equilibrium point, where the demand and supply curves intersect. At this point, the quantity consumers want to buy equals the quantity sellers want to sell.

The equilibrium price tends to remain stable because:

• If the price rises above equilibrium, excess supply occurs, pushing prices back down.
• If the price falls below equilibrium, excess demand occurs, pushing prices back up.

Financial Markets: More Complex Dynamics

Applying these concepts to financial markets still holds true, but the factors influencing demand and supply are more complex.

Demand factors in financial markets:

• Macroeconomic conditions (growth, interest rates, inflation)
• Money supply in the financial system
• Investor confidence in the economy and corporate performance
• Expectations about monetary policy and political stability

Supply factors in financial markets:

• Corporate decisions on issuing new shares or buybacks
• Initial Public Offerings (IPOs)
• Regulations and market rules
• Companies’ access to funding

From Theory to Trading: Demand and Supply Zones

Traders and investors have long understood that stocks and financial assets behave similarly to natural commodities. Both fundamental analysis and technical analysis incorporate supply and demand principles.

Fundamental analysis interprets stock prices as reflecting the demand for the company, influenced by earnings forecasts, economic growth, or structural changes. Changes in these factors shift demand or supply, causing price movements.

Technical analysis features “Demand Supply Zones” (DSZ), a popular technique used to monitor price action and volume to identify areas of strong buying or selling pressure.

Practical Application: Two Main Strategies Using Demand Supply Zones

Strategy 1: Reversal Trading

When prices move to reflect excess demand or supply, they often encounter resistance or support zones. After a period of consolidation (Base), new factors can cause a reversal.

Upward Reversal (Demand Zone Drop Base Rally - DBR): Occurs after heavy selling causes a rapid decline. The price stabilizes, and when buying interest returns, the price rallies again.

Downward Reversal (Supply Zone Rally Base Drop - RBD): Happens after strong buying pushes prices up quickly. Once buying subsides, selling pressure dominates, and the price drops again.

Strategy 2: Trend Following (Continuation Trading)

More common, this occurs when buying or selling momentum persists. The price consolidates in a zone, then resumes its previous trend once new factors reinforce the move.

Uptrend Continuation (Rally Base Rally - RBR): Price advances, consolidates, then continues upward.

Downtrend Continuation (Drop Base Drop - DBD): Price declines, consolidates, then continues downward.

Summary

The concepts of supply and demand are not just economic theories but valuable tools for understanding markets—whether stocks, commodities, or financial assets. Learning and practicing how to apply these principles to real price data can enhance your ability to analyze markets and make smarter investment decisions.