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Understanding Demand and Supply in stocks

Demand and supply in the time of Covid

The price of every product in this world, including stocks, is driven by demand and supply and depending on which is greater, the price either rises, drops or stagnates.

The best example is the correlation between the recent corona virus and the demand for masks. No one was interested in buying masks, until the world started panicking because of an invisible virus. With increasing panic, people realized the importance of masks and the prices of masks increased- in some countries, it even doubled and tripled. Does this mean people will stop buying masks? Obviously not. Because there is a clear demand from people looking to protect themselves and they are ready to pay any price for it, which continues to drive demand.

Who is benefitting in this scenario? Clearly the sellers! They will milk the cow by producing more and selling more, assuming demand will keep rising. However, nothing rises forever! Seeing this massive demand in masks and long term opportunities, more mask manufacturers will enter the market and produce masks trying to get a small pie from this huge demand.

Because of the new entrants and the new supply entering the market at lower prices, the demand will slowly be met and the price will start dropping until there is a optimal price found that benefits both the buyers and sellers.

What happened here is pure demand and supply – at first demand overpowered supply resulting in higher prices and later with increased supply, the price started to drop automatically! This is also the basis for stock markets and one needs to always understand this- by looking at price charts and analyzing how the price behaves over a period of time.

Markets work in a similar way

The price of a stock might not move significantly for a few days, weeks, months or in some cases years because there is an equilibrium between demand and supply of shares! Suddenly, due to some rumors/ insider information/ news the price might start seeing an abrupt increase and buyers will pay any price to buy the stock because they see good prospects ahead. This is pure demand which has overpowered the supply due to which the stock keeps rising until a point where buyers are not interested in buying anymore. So, at this point since there are no buyers and only sellers, the sellers will start selling the stock at any price to get rid of it. This results in the stock moving down.

Let’s take an example

Everyone who buys/sells something is looking to make money, simple! You want to make profit at the end of the day.

If you buy a stock today at Rs.100 and it goes down to Rs.80- you are now in a loss of Rs.20, but you will not want to sell it and go through the pain of that loss. At this point, all you want is your original Rs.100 back at any cost. So, if there is someone to buy at Rs. 100 you immediately rush to sell it at Rs.100 thus recovering your capital. Now, when a big crowd sells at Rs.100 to a small group of people to recover their capital, the supply in the market is overpowering the demand. As a result, the sellers keep dropping the price and the price starts to drop again. This Rs.100 level is called the supply/resistance level because there are too many people selling. The price can only cross this resistance level if there are enough people to buy it. Until then, the price will not cross the resistance level.

In a similar way, let’s say you buy a stock today at Rs.100 and the price starts to keep going up from here to Rs.150. Now, you have made a profit of Rs.50 and you will be happy to sell it off along with others who are in good profits. Due to this increased supply, the price drops back to let’s say Rs.100. Many would have missed this profit making chance from Rs.100 to Rs.150. Now, seeing the price back at Rs.100, these folks who missed the party will enter- causing the price to move up again. So in this case, this level of Rs.100 is called the demand/support zone.

It is not necessary that these levels will always behave as explained in the example above. Sometimes, they go beyond these levels. These levels are just potential levels where demand and supply might show up.

All this can be observed in the price charts of anything that is traded in the world. But to read a price chart, the first thing to do is to identify the points of price reversals which actually act as demand and supply levels. I’ve explained this with the example of the Sugar price chart in the image attached below.

I hope this helps you in identifying demand and supply zones. Let me know if you have any questions in the comments below.

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