By Sam Seiden, an experienced equities and futures trader, as well as a trading educator*
Posted: May 29, 2009
Looking at a chart of the XLF (the ETF for the financial services sector), we can see that the demand (support) level suggested that this would be a low risk area to buy the XLF for a bounce, not a long-term trade.
As you can see in the chart (shown below), price in the XLF touched this level on January 10, 2008. Those who bought it then found that the trade had a gain of $2.00 in two days. They might even have moved their stop to breakeven at this point and considered exiting some or all of the position at or near the circled area seen on the chart because that represented some supply (resistance).
Keep in mind that, while the gain is nice, the low-risk entry taken to get that gain is the key point in this trade that needs to be understood. Obtaining gains in trading is one thing. Obtaining them with the lowest possible risk is another story.
The Questions
How can this demand level, which dates back to the year 2003, have meant anything in January 2008? And, are the buy orders that made up the demand back in 2003 the same orders that caused the demand on that day in January 2008?
Back to Basics
Before we get into specific answers, it is important to understand how markets work and why prices move. Price movement in any free market is a function of an ongoing supply and demand relationship within that market. Opportunity exists when this simple and straightforward relationship is out of balance.
Put quite simply, a market is made up of three components: Buyers, sellers and a "widget" being bought or sold. These widgets may be shares of a stock, S&P futures, foreign currencies, bonds or any of many more tangible and intangible widgets.
For example, let’s say the widget is a stock such as the XLF. This stock has some value. That value or "price", as we call it, is determined simply by the supply and demand for the stock, which is the ongoing interaction of all the buyers and sellers taking action with respect to that particular stock.
A market is always in one of three states. It can be in a state:
- Where demand exceeds supply, which means there is competition to buy that leads to higher prices
- Where supply exceeds demand, which means there is competition to sell that leads to declining prices
- Of equilibrium, which means there is no competition to buy or sell because the market is at a price where everyone can buy or sell as much as he or she wants
However, as the market moves away from equilibrium, competition increases, forcing price back to equilibrium. In other words, competition eliminates itself by forcing market prices back to equilibrium. At equilibrium, there is little to no trading opportunity.
The picture shown above is of what a chart would look like after you removed time from the equation. You would see, at each price level, how many willing and able buyers and sellers are present. We can certainly view the same information on time-based charts.
This is done by identifying supply and demand levels as I did with the XLF and others. Not every cluster of trading is a supply or demand level and not every high or low is a demand level. This is all based on an objective set of rules that is, in turn, based on the laws of supply and demand.
The Answers
The fact that this demand level dates back to 2003 does not at all mean it is less relevant than a demand level from a week ago. Typically, supply (resistance) and demand (support) levels from a long time ago are going to produce much better trades than recently produced levels. The reason is that, when price is revisiting a level from long ago, price will be far from equilibrium, which means that the level is ideally placed on the supply and demand curve (large profit margins).
As far as the same willing and able buyers from 2003 still having their orders in the market at that level in the XLF, I think not. As you can see, these are certainly not the exact same buyers and sellers at levels from the recent and distant past; this is pure supply and demand at work.
To use an analogy from the retail world: If you drop the price of most common appliances, you will invite more and more buyers at each price level as you drop the price. Conversely, as you raise the price of that item, demand will decline; supply will increase.
*Reprinted (and modified) with permission from Online Trading Academy (www.onlinetradingacademy.com). Sam Seiden can be reached at sseiden@tradingacademy.com.
