Supply and Demand. How to profit.

When supply and demand are in equilibrium, the price of a stock is stable and will move sideways on a price chart. Day trading is perhaps the purest form of making this determination since day traders react to imbalances to either profit from follow-through where demand continues to exceed supply on micro trends or fade imbalances on reversals. The most common examples are trend reversals where traders seek to buy weakness at support levels and sell strength at resistance levels. Those that react to imbalances on a very micro minute – to minute level are day traders. Others choose to evaluate these imbalances over a series of days, and this is where swing trading comes from. While others are longer term oriented and employ a myriad of techniques from quantitative analysis to fundamental analysis day traders believe that anticipating and predicting movement too far in the future is difficult, risky, and much less profitable.

This proven theory plays itself out in the markets in many ways. Therefore, once you determined a bias, then you implement your strategy. The stock that will be the most sensitive to the impending imbalance to give you the best chance for profit based on what will move the most and fastest will reveal itself through relative strength or weakness. So reading imbalances must be viewed from a number of different perspectives. Whether on one-stock level or an overall market level where competition for dollars occurs, the imbalance is best views as a cause-and effect relationship. Price changes based on the money flow from competing markets form the effect that results from the reactions of professional and amateur market participants to news and events that are the cause of these prices changes. An example is the activity of the arbitrageurs who trade futures contracts with equities: Money will flow from equities to futures, affecting a negative impact (selling equities) on stocks while money is flowing into phenomenon is felt for only a short time in this scenario, the financial futures market is a vehicle for speculators to bet on points is that supply and demand imbalances are the most accurate precursors to price action regardless of the vehicle being traded. The tools adopted and used to form a bias on a variety of time horizons will vary according to an individual’s technique and style of trading, but in the end this common critical rule of trading does and always will operate in capitalistic markets. This first rule is the foundation of all rules for active trading, and all trading for that matter.

Day traders must subscribe to this next rule: Don’t wait for certainty. Before diving into this rule, think of stocks as either “thick” or “thin”. Thicker (higher liquid) stocks generally show short-term trends over more time than thinner (less liquid) stocks since the reference to thick and thin relates to the price levels. A thick stock must trade heavy volume at each price before moving up to the next (or down) level. An example would be Intel (INTC) trading heavily on the offer price of $60 where sellers are offering INTC for sale, while buyer (bidders) are paying $60 offer price. For INTC to trade higher, demand at $60 must exceed supply at $60 in order for the bidders to absorb all stock for sale at that price. This will force buyers to pay a higher price where sellers are incented to sell, such as 60 1/8. The heavier the volume at $60 before exhausting the stock for sale at that price, the thicker the stock, and hence the more liquid but less volatile it is. Thinner stocks, with less average daily volume, tend to trade through price levels much quicker up or down since there is less subscription in the issue; therefore, as imbalances occur, thinner issues move more dramatically and faster on much less volume.

Day traders read these prices changes on shorter times horizons than investors, but make no doubt about it; both disciplines are doing the same thing, reading supply and demand imbalances. The tools and techniques, as well as indicators, which help detect these imbalances are often different, but the desire outcome is the same: recognize where the imbalance is to form a breakdown, or reversal. Because active day traders will act quickly while trading stocks that have the propensity to move on thinner volume, this rule comes into play because professionals know that if they wait for the confirmation of news and rumors, they will miss many profitable opportunities. Amateurs feel compelled to wait for confirmation, which causes them to be late and gives the professionals another opportunity to fade their reaction. Amateurs tend to enter trade late and on the wrong side of the market as stocks become thicker and overtraded. Two very typical examples are splits and earnings reports, both major market events that tug hard on both ends of the rope of supply and demand.

Does this mean the professionals are reckless risk takers, trading ahead of news? The answer is no or they would not be professionals. It simply means they spend more time studying the market, have greater focus on their traders, have better analytic tools, and know what to look for when a trade is developing or breaking down. Once enough indicators confirm directional bias, professional speculators tend to act and trade ahead of the impending price move, hence putting them several waves ahead of amateurs who wait fro news to break. Because of this, active traders must have conviction and confidence while reading and reacting to these indications. An aggressive trader acts on the volume and increased activity without waiting for news to be announced. It is often said that a chart and Level II tell the stock’s story before the media do!

Conversely, the amateurs with less sophisticated technology and market acumen will wait for the news to be announced, putting them behind the professional trading community. As the public is also waiting for the news announcements and certainty, professionals are often exiting on the news– “selling into strength” with good news and “buying weakness” on bad news – as the amateur rushes in or out providing liquidity. Although this is just an example, it illustrates the mindset of a professional who trades on market indications without waiting for the certainty of rumors and news. This takes us to our nest set of rules.

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