There are generally two schools of thought when it comes to the markets. The first is the Random Walk Theory, sometimes referred to as the Efficient Market Hypothesis, which states that price movements in securities are unpredictable. Because of this random walk, investors cannot expect to consistently outperform the market as a whole.
Proponents of the Random Walk Theory will argue that applying fundamental or technical analysis to attempt to time the market is a waste of time that will simply lead to underperformance. Investors would, according to this theory, be better off buying and holding an index fund.
This theory argues that stock prices are efficient because they reflect all known information (earnings, expectations, and dividends.) Prices quickly adjust to new information, and it is virtually impossible to act on this information. Furthermore, price moves only with the advent of new information, and this information is random and unpredictable.
Opponents to the Random Walk Theory believe that future price action can be predicted by previous price action. They tend to buy into technical analysis and believe that technical indicators, chart patterns, and trend lines can help predict future price action.
The opponents to the Random Walk Theory have it partially right—you can predict future price action based on previous price history, but not using technical indicators. We use previous price action to show us where areas of excess supply or demand are.
The forces that drive price action in a market are supply and demand.
In this series of articles, you will learn how to plot these areas of excess supply and excess demand. When you know there is a high probability of excess supply or excess demand, you can utilize this information to make better decisions when making a trade in any type of market.
Supply and demand are the forces that drive price in any market.If you have ever taken a microeconomics course, you know that supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium for price and quantity.
The four basic laws of supply and demand are:
1. If demand increases and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.
2. If demand decreases and supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.
3. If demand remains unchanged and supply increases, a surplus occurs, leading to a lower equilibrium price.
4. If demand remains unchanged and supply decreases, a shortage occurs, leading to a higher equilibrium price.
Applying this to trading, supply represents willing sellers and demand represents willing buyers. Look at the following chart. Every time price direction changes, the relationship between supply and demand changed. The areas marked with a red dot are points where supply became greater than demand and the areas marked with blue dots are areas where demand became stronger than supply forcing a trend reversal. When markets are trending upward, demand is greater than supply, and the opposite is true for markets trending down.
Areas where the stock trades sideways in a tight range are areas where supply and demand are in balance.
We can gain a competitive edge as traders if we know where these areas of supply and demand are. We plot them on our charts as supply zones and as demand zones.
We can determine where these areas of supply and demand are by looking at previous price action. We need to first learn how to plot these zones, and then we need to learn how to identify the zones that have the highest probability of giving us a profitable trade setup.