Level 2 Tip: Understand Supply and Demand

Most people are aware of how supply and demand works. Chances are you learned it for school, business, or some other reason. It is an extremely basic concept, yet a lot of people tend to forget how applicable it is.

I don’t really care about how supply and demand work at a macro scale. I’ll leave that to the economists. What I do care about is the psychology behind supply and demand because it affects the markets. Before we move on, let’s look at a basic supply and demand chart and draw some basic insights.

supplyanddemand

I’m sure you’re familiar with this chart, but a good refresher couldn’t harm. You can draw a lot of insights from this graph, but there is one I care most about for this post.

As supply goes up, demand goes down.

Yes, this is very basic, but start to think about it in terms of the stock market. The psychology behind it is extremely powerful.

When it comes to the market, “supply” would be the sell orders or the ask prices, and demand would be the buy orders or the bid prices. This is how you should be thinking of Level 2 screens. They simply supply and demand tables.

supplyanddemandl2

Now, that we look at a Level 2 through a supply and demand lens, we can understand how every single order affects the balance of the stock market. Now, let’s draw one more insight from the supply and demand chart before we move on.

As demand increases or supply decreases, the price goes up.

As supply increases or demand decreases, the price goes down.

Let’s apply this to the market. As the orders on the bid side of a Level 2 screen increase in volume and price, the stock price goes up. As the orders on the ask side of the Level 2 screen increase and volume and decrease in price, the stock price goes down. This is still basic economics, but it needs to be understood before we move on.

What is the point of all this?

I get it, you didn’t like economics in high school, so why am I bringing it back to haunt you now? The answer is simple; understanding how supply and demand works can help demystify a Level 2 screen. Level 2 screens may look complex, but they are incredibly simple. You need to understand how they work before you can gain any valuable insight from them.

The bigger point here is learning how to time your entries and exits properly with respect to supply and demand. This is incredibly helpful when dealing with illiquid penny stocks. I don’t put as much thought into this when dealing with higher volume big board stocks that trade thousands of shares per second. There’s usually not enough time to do an in-depth analysis. For illiquid penny stocks, analyzing a level 2 screen from a supply and demand perspective can give you great insight into how a stock will perform on any given day. I use this type of analysis to predict how certain stocks will perform during a day based on supply and demand. I will also place my orders in a way that will be most beneficial to my end goal.

Let’s look at an example

Here is an example that comes straight from today’s trading session. Before scrolling down to see my insight, do a quick analysis to see what you can infer from this Level 2 screen.

supplyanddemandexample

For the first three price levels (as shown by different colours), we can see this:

There are 185,000 shares on the bid side (demand).

There are 1,626,000 available on the ask side (supply).

So, supply is greater than demand, and, as we know, that is an easy way for a stock to go down in price. Yes, other factors play a role, but this article is focused on the Level 2 analysis. Does this mean the stock will automatically go down? Of course not, but it would be much easier for the share price to go down than it would to go up because it would take less volume.

This is intended for determining intraday trends, as the Level 2 screen will change the next day. Also, keep in mind that supply and demand levels can shift intraday, with or without a catalyst. The supply and demand distribution can help you understand the psychology of the traders involved in a given stock.

Here are some insights we can take away from this Level 2 screen.

Buyers are in control – There are so many people trying to sell this stock, yet only a few people trying to buy it. Sellers are trying to unload over 1.5 million shares. If they sold into the bid, they would drive the price down too far and wouldn’t get the exit they desired. Therefore, someone who is bullish can take advantage of this setup to get cheap shares. If someone put in a buy order for 500,000 shares anywhere between .0042 and .0045, they would be offering the sellers a chance to unload a lot of shares. The order may not get filled, but that is okay. It’s not like there is a lack of shares available.

Sellers are being foolish – This is by far one of the most frustrating things that can happen when trading these kinds of illiquid penny stocks. A stock will be having a slow day or be moving up gradually and someone will try to unload a large amount of shares. People complain about this all of the time, often referring to these huge orders as “walls” or “blocks” on the ask. These walls deter buyers from buying shares at the asking price because there are so many shares available (Supply is greater than demand). Buyers want to buy shares when they think a stock will go up. A huge “wall” on the ask makes it difficult for a stock to move up. Notice that there were only 3.3 million shares traded this day. Yet, someone is trying to unload 860,000 shares in one order. It would take roughly  25% of the daily volume to fill that order alone and there are still plenty of other orders that need to be filled. I don’t like complaining about other people’s trading styles, because they should just be accepted as part of the market environment. That being said, there are certain strategies that are counterproductive. When you put a huge block of shares on the ask during a low volume day, you are hurting your own cause. You want to sell your shares, yet you are creating a supply and demand distribution that favours buyers. Think about it. People don’t line up hours in advance to get the new iPhone because they know there are plenty to go around. They line up because they know supply is low and demand is high. People are literally fighting to spend their hard-earned money on an expensive product. Do you think there is a low supply of iPhones because Apple didn’t have time to make enough? Don’t be naive. Apple understands supply and demand and uses it to their advantage. Sure, it would be nice to sell a ton of phones all at once, but, ultimately, that would hurt their cause. The point is simple. When you are selling shares, you need to do so at the right time and in a way that will support your end goal. This leads to my next point that combines my first two points.

Some days are meant for buying, others are meant for selling – As a swing trader, it is crucial that you understand this. Not every day is going to be a good day for selling shares and you cannot be panicked by price dips. Some days are meant for buying, even if you already have shares. A simple look at this level 2 would tell you that sellers outnumber buyers, and, therefore, buyers are in charge. If you are looking to buy shares, this would be a great day. If you are looking to sell shares, you will want to wait because every order you add to the ask (supply side) gives the buyers more power. When buyers are in charge, it doesn’t mean the long term trend will be bearish, but the daily trend certainly won’t be bullish unless the supply and demand levels shift. Success in the stock market is all about seeing what others don’t. You can take advantage of panic, greed, and hype if you have good foresight.

Trying to sell a large number of shares on a day when buyers are in charge is like showing your hand in a game of cards. You are giving your opponents an advantage. You are saying “I am willing to sell all of these shares at this price” when there is a slim chance that you will ever get your order filled. Now buyers know your exact plan, but you don’t know theirs. Maybe buyers were willing to pay more for the shares before they saw how many you were willing to sell at a certain price. Maybe they would have bought your shares progressively if you didn’t show them all at once. Be smart. Test the waters and see what buyers are willing to do.

Start with a smaller order and see how buyers react. The same thing applies to buy shares. No need to put in a huge order as the highest bid. Start small and see if the sellers come to you. Sure, you may rack up some more broker commissions, but you will have a better plan that will make you more money in the long run. In short, understand whether the level 2 setup for the day favours buyers or sellers and plan accordingly. Be smart and be patient. You may want to get in or out of a stock fast, but planning entries and exits properly is far more important.

You can “manipulate” a level 2 screen in your favour – Last but not least, understanding the supply and demand distribution can actually help you manipulate a stock in your favour. The word manipulate can have a negative connotation, but that is not the case here. You are not doing anything shady. You are simply placing strategic orders to support your end goal. On this particular day, sellers were clearly in charge. Buyers wanted to buy 185,000 shares and sellers wanted to sell 1,626,000 shares. There is an imbalance. Anyone who looked at the Level 2 screen would be hesitant to start buying shares because the price could drop fast if someone sold into the bid. If you want to show the market that there is more demand for this stock, you can create that demand by building bid support.

If you placed a few orders totalling 1,000,000 shares on the bid side, there would be a better balance. Of course, you better be prepared to pay for those shares, however, sometimes, just showing the bid support is enough to push a stock price up. You should never use this solely as a bluff, but if you are bullish on a stock, you can use this strategy to share your sentiment with the market. The market may see the bid support and decide to buy on the ask because they have a nice safety net if things don’t go as planned. This is most feasible when you already own shares and want the price to go up. Otherwise, it is pointless. Think about this. If you have been watching level 2 screens for awhile you have definitely experienced this setup.

Stock is running up or down and then it hits a huge order on the bid or ask. This order acts as a wall because it would take a lot of shares to break past it. A lot of the times this order won’t even be fully filled, but the fact that it is there is enough. For example, let’s say a stock has run from .03 to .035 intraday on 10 million shares of volume. Traders are bullish until someone puts an order to sell 2,000,000 shares at .0351 on the ask and suddenly momentum slows. People make take chips off the ask but the stock bounces back down.

The seller may only sell a few hundred thousand shares, but they were able to push the price down because they messed with the psychology of the market. All of a sudden, many traders will go from being bullish to bearish in the short term as a trend reversal may be in the works. This seller made it seem like it would be difficult for the stock to break past that point, so people start taking profits in case the stock drops. Of course, sometimes all of the shares will be purchased, which is why you never want to do this solely as a bluff. It is a tool and it needs to be used properly. This strategy should only be attempted if you know what you are doing.

In Conclusion

This article ended up being much longer than I planned, however, there was a lot to say. The main point is that you need to understand how fragile the markets are and plan your orders accordingly. You can’t simply place orders at a certain price because it’s what you want. I’d love to get my ideal entry and exit for every trade, but that’s not always feasible. You need to react to the market conditions and place trades around them. Remember, there are traders who watch the level 2 screens for a stock all day. These traders analyze every order that comes onto the screen. You want to send the right message. Focus on what your order says to the market.

Always try to figure out whether sellers or buyers are in charge each day and formulate a plan accordingly. Think about the psychology behind the level 2 screen and learn to analyze it without emotion. Remember, your biases don’t matter in the short term. You may think a company is amazing, but if people are selling off, you will want to create a plan to react. Maybe you will increase your position that day. Maybe you will sell some shares to lock in profits. The choice is yours. If you can master the art of analyzing a level 2 screen, you will have a competitive edge over other traders.

Source Link  upperdivisioninvesting.com


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