What causes stock prices to move? Understanding how Demand and Supply drive the market

If you’ve noticed that stock prices sometimes rise rapidly and other times plummet suddenly, it’s not just coincidence. It’s the result of clashes between buyers and sellers. This phenomenon in economics is called Demand and Supply, which forms the foundation for price determination in markets for goods, financial assets, and even stock exchanges. For investors aiming to predict where prices are headed, understanding demand and supply is key to in-depth analysis.

What Are Demand and Supply: The Clash Between Buyers and Sellers

If we observe the busy stock market daily, we see many buyers trying to purchase shares at the highest possible prices with available funds, while many sellers want to sell at the lowest acceptable prices. The struggle between these two sides is demand and supply.

In simpler terms, demand and supply refer to the desire to buy (demand) and the desire to sell (supply). It might seem complicated at first glance, but breaking it down makes it clearer.

1. Demand - Factors Driving Prices Up

Demand is the desire to buy goods or stocks at various price levels. When plotted on a graph, it creates a demand curve, where each point indicates the quantity buyers want at that price.

Basic rule: When prices fall, demand increases; when prices rise, demand decreases. This is natural because investors tend to buy more when prices are low and less when prices are high.

Factors influencing demand include:

• Income effects: Lower prices mean buyers’ purchasing power increases, allowing them to buy more.
• Substitution effects: When a stock’s price drops, buyers may choose this stock over similar alternatives.
• Other factors: Company profit forecasts, government policies, market confidence, and investor sentiment.

2. Supply - Factors Driving Prices Down

On the other side, supply is the desire to sell goods or stocks at various price levels. Sellers tend to offer more shares when prices are high, feeling they can profit more, and offer fewer when prices are low.

The law of supply is opposite to demand: When prices increase, supply tends to increase; when prices decrease, supply tends to decrease. Sellers are less willing to sell when prices are unattractive.

Factors affecting supply include:

• Production costs and capacity
• Future price expectations
• Company policies like share buybacks or issuing new shares
• Management outlook and business trends

3. Equilibrium - The Price That Stays Still

Understanding only demand or supply isn’t enough to determine the stock price. The actual market price occurs at the equilibrium point, where demand and supply curves intersect.

At this point, the quantity buyers want to buy equals the quantity sellers want to sell, so prices tend to stabilize.

If prices deviate from equilibrium:

• If prices go too high: Sellers increase supply, buyers reduce demand, leading to excess supply and a price correction back to equilibrium.
• If prices go too low: Buyers want more, sellers want to sell less, causing shortages and prices rising back to equilibrium.

The Role of Demand and Supply in Financial Markets

In financial markets, asset price movements are influenced by complex, interconnected factors. Understanding demand and supply helps investors better anticipate these changes.

Factors Creating Demand in Financial Markets

• Favorable macroeconomic conditions: When the economy grows and interest rates are low, investors seek better returns in stocks, increasing demand.
• High liquidity: More money circulating in the system means more funds available for risky assets.
• Market confidence: Optimism about future growth attracts buyers, boosting demand.

Factors Creating Supply in Financial Markets

• Corporate policies: Issuing new shares increases supply; share buybacks reduce it.
• Initial Public Offerings (IPOs): New companies entering the market add to supply, which can pressure prices short-term.
• Regulations: Rules about selling restrictions or lock-up periods affect how much stock is available.

How Traders Use This Principle

Since stocks are commodities, analysts can apply demand and supply principles in both fundamental and technical analysis.

In Fundamental Analysis

When stock prices move, investors say “demand is rising” or “supply is decreasing,” but these changes are driven by expectations about the company’s future.

• Good news (profits, growth): Buyers are confident and willing to pay higher prices, pushing prices up.
• Bad news (losses, poor outlook): Sellers dominate, pushing prices down.

In Technical Analysis

Traders use tools to observe buying and selling pressures directly from price and volume movements.

1) Candlestick Analysis

• Green candles (close > open): Demand wins; buyers control.
• Red candles (close < open): Supply wins; sellers control.
• Doji (close near open): Indecision; neither side dominates.

2) Trend Following

• Higher highs and higher lows indicate strong demand; prices likely to rise.
• Lower lows and lower highs suggest strong supply; prices likely to fall.
• Sideways movement indicates balance; waiting for new signals.

3) Support and Resistance

• Support: Price level where buyers tend to step in, indicating demand zones.
• Resistance: Price level where sellers tend to emerge, indicating supply zones.

Popular Trading Strategies: Demand and Supply Zones

The “Demand and Supply Zone” technique uses these principles to identify entry and exit points by spotting areas where demand or supply enters during rapid price movements and reverses.

Reversal Trading

1) DBR (Demand Zone Drop Base Rally) - Supply enters then recedes

• Price drops sharply (heavy supply)
• Pauses at a balance zone
• Reverses upward (demand regains control)
• Traders buy on breakout

2) RBD (Supply Zone Rally Base Drop) - Demand enters then recedes

• Price rises sharply (heavy demand)
• Pauses at a balance zone
• Reverses downward (supply regains control)
• Traders sell on breakout

Trend Continuation Trading

1) RBR (Rally Base Rally) - Demand continues

• Price rises → pauses briefly → rises again
• Demand remains strong; traders buy more

2) DBD (Drop Base Drop) - Supply continues

• Price drops → pauses briefly → drops further
• Supply remains strong; traders sell more

Why You Need to Understand Demand and Supply

Demand and supply are fundamental mechanisms driving prices across all markets—commodities, futures, currencies. Mastering this concept enhances investment decisions.

Investors who understand demand and supply can:

• Predict price directions more accurately by reading market buying and selling pressures
• Time their entries and exits better using both fundamental and technical signals
• Manage risks effectively by understanding why prices change

While learning and applying these principles takes time and practice, diligent study of real market movements will gradually clarify the picture, leading to more effective investment decisions.