The laws of supply and demand: fundamentals investors need to know to predict prices

Understanding supply and demand is not just a piece of economic knowledge—it’s the key to understanding how asset prices move in financial markets. Whether it’s stocks, commodities, or currencies, the laws of supply and demand underpin every price change. Investors who grasp this principle can make more effective investment decisions.

Why Are Supply and Demand Fundamental to Price Setting?

In reality, market prices are not set by any one individual but result from the clash between two forces: buyers and sellers. When buying and selling pressures are balanced, the point where they meet is called the “equilibrium point.”

When buyers see the price as fair, they won’t increase their bids in the opposite direction. Conversely, when sellers think the price is too low, they become less willing to sell. This makes the price unstable. Strong buying pressure pushes prices higher, while strong selling pressure pulls prices down.

Factors Behind Changes in Market Demand

Demand for financial assets isn’t solely dependent on price. Many other factors influence investment decisions.

When monetary policy loosens, investors tend to seek higher returns from the stock market, increasing buying pressure. Conversely, when liquidity tightens, investment capacity decreases. Macroeconomic factors like growth rates and inflation also affect the expected returns of investors.

Investor confidence is also crucial. When markets are optimistic about the economy and company performance, investors are more willing to buy. When concerns or negative news arise, demand decreases accordingly.

Factors Controlling Supply in the Financial Market

On the supply side, decisions by companies to buy back shares or issue new stock directly affect market supply. When a company completes a share buyback, the number of shares in circulation decreases, reducing supply. Conversely, issuing new shares increases supply.

Market regulations also play a significant role. Conditions such as the Silent Period after an IPO restrict major shareholders from selling, preventing immediate increases in supply.

How to Identify Buy and Sell Signals from Price Movements

Investors and traders can read supply and demand signals from candlestick patterns. A green candlestick indicates closing higher than opening, showing buying pressure outweighs selling. A red candlestick indicates weakness in buying.

Observing price trends is another method. If prices continually reach new highs, buying strength remains. If prices keep hitting new lows, selling pressure dominates.

Support and resistance levels reflect the balance between these forces. Support is the price level where investors see as a good entry point, while resistance is where they are prepared to sell.

Applying Supply and Demand Laws in Trading

Demand Supply Zone techniques are popular tools for applying these principles in trading. They identify points where prices move rapidly (“run”) followed by consolidation (“base”).

When prices drop sharply and then stabilize within a range, it’s called a “Demand Zone Drop Base Rally” (DBR). The idea is that excess supply previously existed, but after the price drops, buying interest enters the range. When new factors favor buyers, they overpower sellers, causing the price to jump out of the zone.

Conversely, when prices rise quickly and then consolidate, it’s called a “Supply Zone Rally Base Drop” (RBD). Here, excess demand existed earlier, but as prices go higher, selling interest enters the range. Negative factors then cause the price to break down from the zone.

Traders can enter trades when prices break out of these zones, setting stop-losses at appropriate levels. Timing is crucial because these opportunities don’t occur all the time.

Summary

The laws of supply and demand are not just economic theories in textbooks—they are the mechanisms that drive daily market activity. Understanding how buying and selling forces operate, and what factors cause their shifts, helps investors better predict and capitalize on market movements.

Whether through fundamental or technical analysis, knowing “how supply and demand determine prices” is a core skill every investor should develop. Remember, studying and practicing in real markets is the only way to truly deepen your understanding of supply and demand.