Supply, Demand, and Price Distension

“Overbought” and “Oversold”

Supply and demand are subjects that are widely misunderstood in the context of the capital markets. This is because the total number of shares available for a given security is generally fixed. The float – i.e., the number of outstanding shares available for trading – is generally fixed. The float for a company only changes if the company issues more shares or if a company has a "stock buyback" - purchasing their own stock from investors in order to reduce the total number of shares outstanding.

In the capital markets, "supply" is most accurately defined as "desire to sell" and "demand" is best defined as "desire to buy". Neither desire to sell nor desire to buy are fixed. They vary with price, so measuring supply and demand for securities is more closely akin to price elasticity than it is to the usual economic model of supply and demand for goods and services.

"Price elasticity" is a measure of the change in demand in response to a change in price. Unfortunately the equation is very complex in capital markets because price not only changes the desire to buy, it also changes the desire to sell. And these desires are both further complicated by the influence of the expectations of potential buyers and potential sellers.

Trades occurs when buyers and sellers agree on the current price and disagree about the future. The buyers believe the price will increase in the future. The sellers' motives may come from a variety of sources. The sellers may believe the price will decrease in the future, or they may believe that other securities will increase faster in the future, so they are selling one security in order to generate capital to purchase others. Also, sellers sometimes just need the cash.

To further complicate matters, desire to sell and desire to buy can be strongly influenced by the prevailing rate of change in price. If prices in general are falling rapidly, as we saw in the second half of 2008, then buyers may not be willing to step in even when price is at levels they would normally see as bargains.

“Overbought” means price has advanced rapidly, moving above the CMV, and there is no one willing to buy at the current “inflated” price. In other words, desire to buy has been satiated.

Imagine the situation where everyone is excited about the stock for Arizona Beach Front Properties, Inc. People start buying the stock and their purchases shift the market price from $10 a share up to $12 a share. At this point price has moved above the current CMV and buyers are no longer willing to purchase it at that price.

The term "oversold" refers to a short-term decline that has pushed prices so far below the CMV that people who desire to sell their shares aren't willing to do so at such a low price. The supply – the desire to sell – has been exhausted.

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