Supply and demand - from textbook to the order book

Supply and demand are the most obvious concepts in economics and the most misused ones in trading. In a textbook the curves intersect and set the equilibrium price. In the market there is no single equilibrium price – there is a continuous auction in which demand and supply show up as orders, volume and the reaction at a level. If you cannot translate the theory into what you see in the order book, you will draw lines and call them “demand” while they are only your hope.

This lesson explains how to recognise the real pressure of buyers and sellers, how to measure elasticity, and what it means when the market “does not respect” support.

Supply and demand – an operational definition for a trader

In economics:

• Demand: how much of a good buyers want to buy at a given price.
• Supply: how much sellers want to sell at a given price.

For a trader, operationally:

• Demand = buyer aggression + passive absorption on the bid. You see it as volume on up moves, defence of a level, fast buy-backs after a dip.
• Supply = seller aggression + no takers on the bid. You see it as volume on down moves, rejections at resistance, a gap on the bid side.

The law of demand and supply still works, but in a financial market both curves shift within milliseconds, because expectations about future rates, earnings and risk change without pause.

Elasticity – why the same piece of information moves the market sometimes and not other times

Price elasticity of demand measures how strongly demand reacts to a change in price.

Demand_Elasticity = (% Change_in_Demand) / (% Change_in_Price)

Elastic demand: |E| > 1 -> a small price change triggers a large change in demand (e.g. meme stocks)
Inelastic demand: |E| < 1 -> the price can move a lot while demand barely reacts (e.g. US Treasuries in a crisis)

Three types of elasticity matter most to a trader:

1. Elasticity with respect to price: When an ETF falls 5% and volume rises 300%, demand is elastic – someone is reacting. When it falls 5% on volume at 30% of the average, there is no demand, but no panic either.
2. Elasticity with respect to information (news elasticity): The same better EPS result gives +5% in a bull market and +0.5% in a bear market. The market is less elastic to good news when fear about macro dominates.
3. Supply elasticity: How many new shares/ETFs can appear at a given price? A company with a large float has more elastic supply – a short squeeze is harder.

The order book as a picture of supply and demand right now

Theory becomes practice when you look at the order book.

Two measurable patterns:

Demand_Imbalance = Sum_of_Bid_Volume / (Sum_of_Bid_Volume + Sum_of_Ask_Volume)
If Imbalance > 0.65 -> short-term demand dominance

Absorption = Volume_at_Level / Price_Change_at_Level
High absorption at support = someone is defending, not just a line on a chart

Support and resistance are not lines; they are zones where inelastic supply/demand historically appeared. If a zone has been tested 5 times, the supply/demand inside it is weaker every time (the orders have been eaten). Traders draw it a 6th time and are surprised that “the level did not work”.

Curve shifts – what really shifts them

In a textbook 4 factors shift the curves. In a financial market it is the same, only faster:

• A change in income/the cost of money: a rate cut = a rightward shift of demand for stocks (more buyers at a higher price).
• A change in risk preference: risk-on / risk-off is a mass shift of demand from bonds into stocks and back.
• A change in the number of buyers: inflows into ETFs, share buybacks – an artificial shift of demand.
• A change in expectations: company guidance, a change in the CPI forecast – it shifts both curves.

A practical example: an ETF on semiconductor companies.

• News: Taiwan – an earthquake, risk to the fabs. Chip supply is supposed to be smaller, but in the short term the fabs are standing still. What shifts?
• In the short term: the supply of semiconductor shares rises (selling out of fear) -> the supply curve shifts right -> the price falls.
• In the medium term: the supply of the chips themselves falls -> chip prices rise -> company earnings rise two quarters later -> demand for the shares shifts right -> the price rises. A trader who looks only at today’s supply of shares will miss tomorrow’s demand for the product.

When the plan says DO NOT TRADE

1. When you cannot see where the real supply/demand is, only lines. If you cannot say whether there is a real bid of 50k shares at the PLN 100 level or just your rectangle, you do not have a plan – you have a drawing.
2. When volume does not confirm the move. The price rises on falling volume at resistance – demand is weakening and supply will soon take over. Going long here means entering where demand is exhausted.
3. When the market is inelastic to your thesis. You go long on good data, but the market is in risk-off mode and every piece of good information is ignored. That means the demand curve has shifted left for good today. Do not fight a shift of the entire market.
4. When spread and slippage eat the edge from supply/demand. The instrument has a wide spread of 0.3% and you want to capture a 0.5% move from support. Your real supply/demand is the spread, not the chart.

The mistakes that cost the most

1. Treating support/resistance as a wall rather than a zone of absorption. A professional measures how much volume was absorbed. An amateur counts how many times the price bounced. After the 3rd or 4th bounce the real supply/demand is already used up.

2. Ignoring hidden supply (shorts, issues, ETF creation). The price reaches resistance and suddenly a huge supply appears – that is not “someone suddenly decided”. Those were iceberg orders, expiring options, ETF creation units. If you do not monitor float and open interest, you suddenly end up on the other side of an institution’s trade.

3. Confusing demand with FOMO. Volume rises and the price rises fast – you think this is strong demand. Often it is the last, most elastic retail demand buying the top. The indicator: retail versus institutional volume – the rate of growth against a falling bid depth.

4. Not measuring the elasticity of your portfolio. You buy 3 ETFs with the same exposure to demand for risk (beta >1.2). You think you have demand from 3 sources. You have 3x the same demand. On a risk-off day everything falls together, because it is the same demand curve.

Measurable exercise [20 minutes]

Goal: Learn to tell noise from real absorption at a level.

Pick one mid-liquidity stock from the WIG20 (the Warsaw Stock Exchange blue-chip index) or one liquid ETF.

1. On a 5-minute chart, mark 2 visible support levels and 2 resistance levels from the last 5 days.
2. For every approach of the price to a level, record:

Date_Time | Level | Volume_15min_before | Volume_at_Level | Price_reaction_15min_after | Bid/Ask_Imbalance (if you have Level2) | Conclusion: defended / not

3. Calculate:

Level_Hit_Rate = Number_of_defences / Number_of_tests
Average_absorption = Average_volume_at_Level when defended

Pass criterion: You have at least 8 tests and you can point to one level where absorption was >150% of the average and the price actually turned back. You remove the rest from the chart – those were lines, not demand.

Test yourself

1. The price falls on volume 3x larger than the average, but a large buyer keeps appearing on the bid and replenishing the order. What is this? a) Weak demand, run away b) Passive absorption – someone is defending the level and the supply is being absorbed c) Manipulation, it cannot be measured

Correct: b) This is a classic example of demand that does not push the price but absorbs it – visible in the imbalance.

2. An ETF rises 4 days in a row, but the volume is smaller every day. How do you assess demand elasticity? a) Demand is strong and inelastic b) Demand is weakening, elasticity is falling – exhaustion is approaching c) Volume does not matter

Correct: b) A rise without volume means little new demand, and a pullback comes easily at the first supply.

3. What shifts the demand curve for stocks to the right? a) A fall in real interest rates and an improvement in earnings forecasts b) A rise in real rates and a deterioration in forecasts c) Technical analysis alone

Correct: a) A lower cost of money and higher expected earnings mean more buyers at any price.

Frequently asked questions

Do demand/supply zones always work? No. They work when they represent real orders, not drawings. Their strength falls with every test. Measuring volume and imbalance matters more than the colour of the rectangle.

How do you tell absorption from distribution? Absorption at support: high volume and the price refuses to fall lower. Distribution at resistance: high volume and the price refuses to go higher. In both cases volume is high, but the direction of the block is different. You need a footprint / Time&Sales.

Is textbook supply and demand the same as supply and demand in the market? The principle is the same, but in a financial market supply and demand are mainly expectations. The curves shift not because a good is physically missing, but because the expectation about the future price changes. That is why measuring sentiment and elasticity matters more than counting goods.

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This is not investment advice. Supply and demand are tools for measuring pressure and liquidity, not a guarantee of direction.

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