You Can Be a Better Trader By Understanding This One Premise

Since my column started a few weeks ago, I have focused on trends and technical indicators, trying to educate on what to look for when trading stocks to make you a better trader.

 In the foundation of economics, the laws of supply and demand dictate the equilibrium price and whether goods are overvalued or undervalued. The equation taught in economics 101 is quite straightforward, but it is a principle that you should be fully aware of. Here is how it goes:

 When supply exceeds demand, prices tend to trend lower. But when the demand is greater than the amount supplied, there is a supply-demand imbalance, and prices ratchet higher. This simple relationship generally applies to all pricing mechanisms. For instance, take a look at the oil market. The fluctuation is purely dictated by speculation towards the supply-demand equation. What you want to do is to try to establish a trend and trade off it.

 The supply-demand pricing mechanism is the premise behind on-line auctioneer eBay Inc. (NASDAQ/EBAY). Let’s assume you have a rare baseball card. Because it is rare, the supply is limited. And if the demand were strong, you would see a bidding up of the card’s price, as buyers bid. eBay’s business model is excellent. It’s the market leader in this area, especially in North America, but it also wants to dominate other on-line auction markets worldwide. In China, the company spent $180 million acquiring Chinese auction site EachNet in its attempt to make its site the number one player in China’s rapidly growing consumer spending market.

 In the markets, when the demand (bid) for a stock exceeds the supply (ask) at a certain price point, the stock will tend to be bid higher, as new buyers at higher prices surface. At this point, the market stalls, as the number of sellers is greater than the number of buyers. It’s simply a case of an excessive supply of stocks and the inability of buyers to surface. As a result, supply exceeds demand, and the market moves lower. To see a reversal from the current bearish sentiment, we need to see a renewal of buying and demand for stocks.

 A representation of this sentiment is reflected by the market’s breadth, which is represented by the advance-decline line (A/D). The A/D ratio shows the number of advancing issues versus declining issues. An A/D ratio below “one” suggests apprehension, as more stocks are declining than rise. An A/D ratio over “one” suggests bullish sentiment, with more advancing issues.

 In the most recent two-week period, the number of positive A/D days on the tech-laden NASDAQ has increased — suggesting sentiment has turned more positive towards growth and tech stocks. But for the market to regain its bull legs, we need to see a rising A/D line indicating more advancing issues. So far this has yet to materialize as the A/D line for the NASDAQ has largely been negative since February.

 If you follow the stock market, keep a close tab on the capital flowing in and out. A net outflow of capital is a warning sign that demand may be lackluster. But when capital begins to come in on the buy side and from institutions, that’s when we see stocks rise.

 The volume indicator reflects the capital movement. I actually believe volume is just as important, if not more important, than price. For instance, an upticking market supported by rising volume is bullish. But if the volume is weak, it is a bearish divergence and does not support a sustainable rally, since a large number of buyers are absent. The same applies to down markets. You don’t want to see increased volume on down days, as this is a signal to sell.

 Incorporate this premise in your trading strategy, and I firmly believe it will make you a better trader.