What do the Economists Lie to You About Demand and Supply?

A BFP reader emailed me about an article talking about Price being the determinant of future prices of a security. Textbooks and economists have taught us that price is determined by the level of demand and supply. But there is more to it and the reader was kind enough to share with me his experience why aggressiveness can change the entire price dynamics of a security.

I believe price moves not just because of imbalance between demand and supply. The open auction market (covers anything that traded in the open from stock to pork bellies and orange juice) is nothing but a game of “power struggle”. Buyers struggle with sellers. Just like in animal kingdom, the strongest will overcome the weaker one. Imagine this. How can one lion scare off hundreds of zebras? The zebras outnumbered the lions by a massive margin. The lion only has one edge, it is more aggressive. Its aggression puts it in a position of advantage.

I encountered this simple phenomenon when I traded for institutional investors. I can have order size equivalent to the average daily trading volume of a blue chip. I have the firepower to hold the price and swing it any how I like. However, most of the time, the modus operandi is just to pace the market and just be 25%-33% of market volume. By limiting myself to just a quarter of market volume, I have surrendered my aggressive factor to the seller or to the other buyers. Many a times, theres more demand than theres supply but the price still goes lower. I know because I have had the experience of selling or buying up to 5% of a blue chip company. I have the firepower to take on the sellers single handedly. That set me thinking that price moves in the direction of the most aggressive. If seller is more aggressive, the price will drop. If buyer is more aggressive, the price will rise. By buyer and seller I dont mean a single entity. I mean a group as a whole. Those buying form the buyers group and those selling form sellers group. Lets now see how this mechanism work.

All buyers and sellers have one aim in mind: to further their interest in the auction. If I am selling, I want to sell it high and if I am buying, I want to buy it low. So naturally I don’t want to be aggressive. I want the buyer to be aggressive so I may sell at higher price. Now, the buyer have the same thing in mind. He wants the seller to be aggressive because he wants to buy lower. None wants to budge right? If that is so, how can a trade be done? However, lets’ say another buyer steps in and his price is higher and more gung ho and he outbids the first buyer, the whole dynamic has changed. There’s a power struggle not just between buyer and seller but also between buyer 1 and buyer 2. Competition raises aggression and as price move higher it attracts more buyers. Suddenly it becomes a feeding frenzy. Price spirals higher not because buyers were fighting seller, but because buyers were fighting among themselves, each shuffling to buy before the price runs away.

Now you say, there’s more buyer therefore more demand and thus price goes up. Not true. A trade can only be done and price printed when buy quantity matches sell quantity at an agreed upon price. So at any one time, demand=supply when a trade is done. Therefore, the level of aggression of each party (buyer or seller), governs by the level of competition in the game within each camp. If the buyers are more competitive, they become more aggressive the price goes up and when the sellers are more competitive, the price goes down.

I have shared with you my experience with large orders but sedated aggression. Now I have also the experience with small orders but maximum aggression. I remember buying stocks with only 300+k shares in order size. The stocks trades millions per day. My order size was nothing. The stock has not gone anywhere. There was a gridlock between buyers and sellers and between the buyers and sellers themselves. It has not moved the whole day. My client wanted to finish the order early and he was comfortable with the prevailing price. So I lifted the offer and again the next offer to complete the order. The other buyers panic because they missed 2 prints so they decided to be more aggressive. Before I know it, a feeding frenzy got into action and price rallied. What I did was to introduce competition. Competition leads to aggression leads to price movement. More buyers does not mean higher price as there might not be competition.

Posted in: Nature of Financial Markets