Nowadays, trading supply and demand in forex is becoming a very popular topic among traders. Basically, a trader buys low and sells high an asset using supply and demand imbalances to generate profits from price movements.
In this article, we’ll understand how these two factors interact with each other to establish market prices and how professional traders use market imbalances to facilitate their orders in the forex market.
But first, let’s go through the basics of supply and demand.
The Basics of Supply and Demand
Supply and demand is considered one of the most fundamental concepts of modern economics. By definition, it is the study of how buyers and sellers interact to determine market prices and quantities of goods and services.
The concept of supply and demand in forex states that if the supply of a currency is high and the demand is low, this generates excess which drives the price down. If the supply of a currency is low and the demand is high, this creates scarcity and then pushing the price higher.
Thus, traders buy and sell currencies as prices fluctuate based on the laws of supply and demand. When traders buy low and sell high, they simply buy at demand levels and sell at supply levels.
What is Supply?
Supply refers to how much the market can offer for a desired product or a service. The quantity supplied is the amount of a certain good producers are willing to supply when receiving a certain price.
When prices of goods increase, producers are manufacturing more products to increase their revenue.
When prices of goods decrease, producers are also decreasing production because they won’t be able to cover their input costs.
Thus, as prices go up, the quantity supplied by producers also goes up.
As you can see, there is a positive correlation between prices and quantity of goods supplied.
What is Demand?
Demand consists of how much of a product or service is desired by buyers. The quantity demanded is the amount of product buyers are willing to buy at a certain price.
As a result, people will naturally avoid buying a product that is too expensive for them and either find another product or wait for prices to go down.
Thus, as prices increase, the demand for that product or service will decrease.
Unlike supply, prices and quantity demanded are negatively correlated.
Because supply and demand are dynamic forces, we can’t isolate them in real life. They are constantly interacting with each other to establish prices at which goods and services are transacted.
Supply and Demand Curves
The logic behind supply and demand is simple. When supply increases, prices fall, and when demand increases, prices rise.
The demand curve (downward slope) shows the quantities of a particular good or product that buyers will be willing to purchase at each price during a specific period.
The supply curve (upward slope) shows the quantities that sellers will offer for sale at each price during that same period.
When both curves are combined, we notice that both curves intersect at a specific price. This is the price at which buyers and sellers agree upon to complete their transactions at that specific period.
At this price the quantities demanded and supplied are equal. This is called the Equilibrium Price.
In any market, this equilibrium price is the price at which quantity demanded equals the quantity supplied. Think of it as a matching price between buyers and sellers.
With an upward-sloping supply curve and a downward-sloping demand curve, there is only a single price at which the two curves intersect.
This means there is only one price at which equilibrium is achieved.
In real life, consumers are looking for low prices and good deals to buy products, while sellers are seeking the best prices to make profits and cover their expenses.
Thus, a market balance must be reached so that both buyers and sellers are able to engage in ongoing business transactions.
Now that we have a general understanding of how prices are determined in a given market, we move on to see how supply and demand in forex market works and how can we trade it.
Supply and Demand in Forex
In the Forex market, the same concept applies.
When the supply for a currency is high and the demand is low, this will drive prices lower. If the supply for a currency is low and the demand is high, the excess demand will drive prices higher.
Traders use supply and demand in forex to identify price levels where demand exceeds supply or supply exceeds demand to make a profit out of the market imbalances.
The constant battle between buyers and sellers drives the market up or down. Buyers are looking for prices to fall to take action whereas sellers are more active when prices rise.
For example, during times of uncertainty and fear, investors reduce their exposure in the equity markets and start buying safe haven currencies to protect their investments.
The high demand for the Japanese yen will drive the price of the yen higher due to the high demand. The excess demand to buy the yen drives prices higher.
This is also known as the carry trade, where traders buy currencies with high-interest rates and sell those with low-interest rates.
Traders are looking for a fair price to execute their trades. By fair price I mean not paying too expensive or selling too cheap.
The fact that forex pairs don’t have intrinsic value, the way traders evaluate the value of a pair is based on supply and demand.
Let’s take a look at the following chart of EUR/USD:
Since 2008, the European Central Bank (ECB) started decreasing the interest rate below 2% to reach negative rates by 2013. An entire chain reaction is set in motion due to the forces of supply and demand. When rates decreases, forex rollover payments also decrease.
This means that investors that are holding the trade open at the specified rollover time will receive a lower to negative interest rate.
Now more traders would want to sell; and fewer traders would want to buy as the opportunity cost of buying (the rollover payment) has just gotten more expensive.
As you can see, price aims to find a comfortable point and will decrease until there are no more sellers willing to receive that price. At this point, buyers outnumber sellers, and price will respond by moving up.
Learn about the Ultimate Guide to Master Supply and Demand in Forex.
Now let’s take a look at how professionals trade supply and demand in forex charts:
As we said earlier, traders buy low at demand level where buyers exceed sellers according to the laws of supply and demand. Demand is located below current price as shown on the chart below.
Notice how price rallies every time it returns to the demand area. This is because at this demand area institutional orders are sitting there waiting to get filled every time price retraces back down.
If the demand area is running out of unfilled orders, price will move on to find another demand area where buyers exceed sellers and so on.
At the supply are, sellers exceed buyers and price tends to move lower due to the laws of supply and demand. In general, the supply area is located above the current price where selling pressure drives prices low as we can see on the chart below.
Notice how price drops with every retracement back up to the supply area. Same thing happens here, price will keep returning to this supply are until it runs out of unfilled orders. Then price will move away where new market imbalances are created.
The laws of supply and demand can be applied to anything that has value and can be traded. The dynamics of these two forces contribute to the establishment of prices in all financial markets.
Supply and demand in forex follows the same rules as any other financial market. Demand drives prices higher and supply drives them lower. Traders are monitoring the overall health of the economy through macroeconomic data to assess whether to buy or sell a specific currency in the FX market.
Professional traders know how to spot and identify supply and demand imbalances to generate profits. They buy low at demand areas and sell high at supply areas.
Unfortunately, retail traders are doing the exact opposite of what professional do. They buy high at supply areas and sell low at demand areas. They do this because most of the technical analysis books told them so. These technical tools and concepts are not working in forex. Instead, they need to learn how the market works then use the right tools to trade it.