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Price Action Trading Strategy: Supply & Demand Zones

The law of supply and demand is a fundamental principle that shapes all market prices. By understanding this law, traders can gain a deeper insight into market trends and predict future price movements. In this context, supply & demand zones offer a practical application of this economic theory, translating it into a robust trading strategy using price charts. Herein, we will delve into the role of liquidity in supply and demand zones, the significance of different time frames, and the use of oscillators and volume indicators for confirmation.

You will learn how to distinguish between retests and breakouts, recognize potential risks, and understand the best practices for successful trading. Furthermore, we will explore real-world case studies that highlight the successful application of supply and demand zones. Whether you are a novice trader or an experienced market player, this guide promises to enhance your trading skills and extend your knowledge of market dynamics.

So, read on to unlock the power of supply and demand in your trading strategy...

Contents: Supply & Demand Zones

 

What are supply and demand zones?

Supply and demand zones are a popular analysis technique used in day trading. The zones are the periods of sideways price action that come before explosive price moves, and are typically marked out using a rectangle tool in the stocks, forex or CFD trading platform.

A supply zone forms before a downtrend
A demand zone forms before an uptrend

 

supply and demand zone

 

Supply and Demand trading strategies use price returning to these zones as entry and exit criteria. The strategy is market-neutral - meaning it can be traded in forex markets, commodity futures, index CFDs etc.

 

Fundamental Concepts in Trading Markets

When trading financial markets using supply and demand trading (S&D trading), understanding the core principles is crucial. One such principle involves the formation of supply and demand zones, which are indicative of impending market trends.

 

A supply zone is established when the market is poised for a downtrend, meaning there's an excess of goods or securities available and prices are set to decrease.

 

Conversely, a demand zone forms when the market is on the brink of an uptrend, indicating that there's a heightened interest or demand and prices are likely to rise. Identifying these zones is essential for traders who want to predict and benefit from future market shifts.

 

Supply and Demand trading strategies use price returning to these zones as entry and exit criteria. The strategy is market-neutral - meaning it can be traded in forex markets, commodity futures, index CFDs etc.

 

If you want to skip ahead to learn specifically how to draw supply and demand zones you can go to the section The 4 Major Patterns in Supply and Demand Trading. However we heartily recommend you read the following two sections to get a grasp on the rationale behind this trading technique, which will give you extra confidence to use it.

Wykoff & Market Structure

Let’s think about the three simplest concepts in trading financial markets

  1. When demand is greater than supply, the price goes up
  2. When demand is equal to supply, the price goes sideways
  3. When supply is greater than demand, the price goes up down

Financial markets move in phases of the above. There are uptrends and downtrends or price ranges.

Richard Wykoff was one of the first market analysts to explain the interaction of these phases, giving them four labels.

  1. Accumulation
  2. Markup
  3. Distribution
  4. Markdown

They can be seen in Wykoff’s classic schematic of market action:

 

Wykoff market action

 

It is in the understanding of Wyckoff’s explanation of market price action, that supply and demand zones are also known as accumulation and distribution zones.

Wykoff explained these phases by the action of the ‘whales’ which these days are big institutions like money centre banks in forex markets or hedge funds in the stock market.

These big players can’t just put their whole order into the market at once because they are accumulating so much that it would move the price. So instead, they buy increments within a specified price range. This causes what we see on the chart as a ‘demand zone’

Equally, when they are selling their position, it can’t be all done at once because the selling pressure would send the price sharply lower and reduce their profits because they would be forced to sell into a market decline, caused by their own large orders. So again they sell over a period of time to minimise the market impact of their trades, which creates the 'supply zone'.

Eventually the market will break in the way that these whales had been buying or selling, creating a period where supply and demand are out of balance i.e. a price trend.

 

Wyckoff’s 4 phases of market price action generally follows this sequence:

1. Accumulation Phase

   - This is the phase where informed and sophisticated investors (often referred to as "smart money" or "composite operators" in Wyckoff terminology) start to buy or "accumulate" assets, believing them to be undervalued.

   - During this phase, the asset’s price is relatively flat, showing little fluctuation. This can be perceived as a period of consolidation.

   - It often ends with a "spring" or a sudden dip below the trading range that quickly reverses, catching short-sellers off-guard.

2. Markup Phase

   - Following accumulation, the price begins to rise during the markup phase.

   - This is where the broader public starts noticing the upward movement, and more participants join, pushing the prices further up.

   - Periodic pullbacks or consolidations known as "re-accumulation" zones might occur before the uptrend resumes.

3. Distribution Phase

   - After a prolonged uptrend, the asset becomes overvalued. This is when the smart money starts to "distribute" or sell their holdings to the uninformed traders.

   - Like the accumulation phase, the distribution phase appears as a generally flat price movement but with increased volatility.

   - It can end with an "upthrust" or a sudden spike above the trading range that quickly reverses, trapping the late buyers.

4. Markdown Phase

   - Post-distribution, the price enters a downtrend or the markdown phase.

   - During this period, there's a general decline in prices as the broader market starts to sell off, sometimes in a panic.

   - Similar to the markup phase, there can be short-lived rallies or "dead cat bounces" during this phase before the downtrend continues.

 

For traders, understanding these phases is crucial. By identifying which phase a market is in, a trader can make more informed decisions about when to buy or sell an asset.

 

Wyckoff’s explanation of market price action via accumulation and distribution zones inspired the application of supply and demand zones in trading.

 

The 4 Major Patterns in Supply and Demand Trading

First, it’s important to understand that there can be several periods of accumulation during an uptrend and several periods of distribution during downtrends. This means that, just like in classic technical analysis price patterns, there are supply and demand reversal patterns and supply and demand continuation patterns.

Recognising S&D Reversal Patterns

The Drop-Base-Rally is a bullish reversal pattern

The Rally-Base-Drop is a bearish reversal pattern

Let’s explain a little more about how these zones work and how they can be utilized in the trading strategy.

Drop-Base-Rally (DBR) - Bullish Reversal Pattern

How a DBR works

  • Drop: This is a phase where prices are declining, indicating a dominance of supply over demand.
  • Base: After the drop, the price moves into a consolidation or sideways phase, where selling momentum slows down. This is the "base" and it's an area where supply and demand start to reach equilibrium.
  • Rally: Post the base formation, if demand starts to overpower supply, a rally or uptrend commences.

 

Using DBR in a trading strategy

  1. Spot the Base: For this pattern to be valid, the base needs to be well-defined. This often looks like a range or a tight price pattern after a sharp decline.
  2. Entry Point: A breakout above the base is a potential entry point for a long position, signaling that buyers are now in control.
  3. Stop Loss: Place a stop loss below the base to limit potential losses if the price reverses.
  4. Profit Targets: Previous resistance levels or a fixed risk-reward ratio can be used to set take-profit levels.

Rally-Base-Drop (RBD) - Bearish Reversal Pattern

How the RBD works

  • Rally: Prices are on the rise, showcasing a period where demand is overpowering supply.
  • Base: Following the rally, prices enter a consolidation phase. This is where buying momentum slows down, and the market searches for direction.
  • Drop: If supply starts to take over demand post the base formation, a downtrend or drop ensues.

 

Using an RBD in a trading strategy

  1. Identify the Base: After an uptrend, watch for a clear consolidation phase or sideways movement in price.
  2. Entry Point: A breakdown below the base suggests that sellers are taking the upper hand and can be an entry point for a short position.
  3. Stop Loss: To mitigate risks, set a stop loss above the base.
  4. Profit Targets: Consider previous support levels or establish profit targets based on a predetermined risk-reward ratio.

 

In both patterns, it's essential to combine these observations with other technical indicators and analysis tools to validate and refine trading decisions.

Recognising S&D Continuation patterns

The Rally-Base-Rally is a bullish continuation pattern

The Drop-Base-Rally is a bearish continuation pattern

Here’s a detailed exploration of these patterns, including again an explanation and how to use it when trading.

Rally-Base-Rally (RBR): Bullish Continuation Pattern

How the RBR works

  • Initial Rally: An upward movement in price, showcasing bullish sentiment.
  • Base: A period of consolidation. It’s a pause in the upward trend, where buying and selling pressures equalize. This phase may show relatively tight price ranges and decreased volume.
  • Second Rally: The price breaks out of the base, resuming the upward trend, typically on increased volume, indicating a continuation of bullish sentiment.

 

Trading Strategy

  1. Entry Point: Consider entering a long position when the price breaks above the high of the base, especially if accompanied by increased volume.
  2. Stop Loss: Set a stop loss below the base to protect against false breakouts or trend reversals.
  3. Take Profit: Set a target based on previous highs, resistance levels, or using technical indicators for potential exit points.

Drop-Base-Drop (DBD): Bearish Continuation Pattern

How the DBD works

  • Initial Drop: A downward movement in price, showcasing bearish sentiment.
  • Base: A pause in the downward trend where buying and selling pressures find equilibrium. This phase often shows tight price ranges and decreased volume.
  • Second Drop: The price breaks out of the base, resuming the downward trend, typically with an increase in volume, indicating a continuation of bearish sentiment.

 

Trading Strategy

  1. Entry Point: Consider entering a short position when the price breaks below the low of the base, especially if it's on higher volume.
  2. Stop Loss: Set a stop loss above the base to protect against potential price reversals or false breakouts.
  3. Take Profit: Establish a target based on previous lows, support levels, or employ technical indicators to identify potential exit points.

 

Understanding which phase the market is in i.e. what is the underlying trend and how long has it been in place determines which are the best demand and supply zones to look for.

 

In an old trend, you will want to look for reversals. In a new trend you will want to look for continuations.

 

Understanding the role of liquidity in supply and demand zones

The market is largely driven by supply and demand. For a market to function efficiently, it needs liquidity, which refers to the ease with which an asset or security can be bought or sold without impacting its price. Supply and demand zones are the key levels where most of the trading activity happens. In these zones, liquidity is usually high, which makes them ideal points for trading. High liquidity allows traders to execute trades quickly and at more favorable prices.

 

How to draw Supply & Demand Zones

Let’s elaborate on Step 5, which concerns how to draw supply and demand zones.

There are two types of candle zones to look for on the chart, either one will proceed a big price move.

  1. From a base
  2. From a single candle

Supply/Demand Base

In trading terms, a base is typically another way of referring to a bottom. But in the context of supply and demand, a base means a small series of candles (typically less than 10) in a tight consolidation.

 

supply zone vs demand zone

Single Japanese Candlestick

This is simply when one candle is enough to draw the zone. The two candlesticks together often form a classic Japanese candlestick pattern like a hammer or shooting star or bullish and bearish engulfing candlestick patterns.

 

single candle demand supply zone

 

 

Significance of time frames in supply & demand zones

The time frames play an essential role in supply and demand zone trading. Different time frames can show different market trends, and traders often use multiple time frames to get a comprehensive view of the market. For instance, a longer time frame can show a major uptrend, while a shorter time frame might reveal a temporary downtrend. Using these time frames, traders can identify the overall trend and find optimal entry and exit points. 

 

How do you identify a strong supply and demand zone?

Like in any form of technical analysis or trading strategy, there are strong signals and weak signals. To get the best trading results, we need to ignore the weak signals and take the strong ones.

The perfect supply and demand trade setup will see the zone exhibiting all of these features:

 

  1. Narrow price range

If the trading range that exceeds the breakout is too wide or has too many long-wick candles, it shows uncertainty and is less likely to represent accumulation from a whale.

  1. Less than 10 candles

The demand or supply zone should ideally be between 1 and 10 candles. Accumulation and distribution can take a while but too long and the zone may get exhausted before the re-test later.

  1. Strong price move

What we want to see in the breakout candle is an ‘Extended range candle’ or ERC. This shows a strong price move that has significance.

  1. Fresh / untested

The best zones are when the price has not revisited it since the breakout. Just like support and resistance, the more times supply zones and demand zones are test, the more likely they are to fail.

  1. Fakeout or ‘spring’

This is when the price temporarily breaks out in the opposite direction but then quickly reverses. This is a sign of big players ‘stop hunting’ to find extra liquidity for their accumulation or distribution.

 

How do you mark a supply and demand zone?

Putting this theory into practise, the idea is to find the place on the chart where demand overcame supply (for long trades) or where supply overcame demand (for short trades).

Let’s go through the process for correctly identifying supply and demand zones.

 

how to identify supply and demand zoneSource: FlowBank Pro Trading Platform

STEP 1: Identify current market price

STEP 2: Look left on the chart

STEP 3: Look for big green or big red candles

STEP 4: Find the origin of the big candles

STEP 5: Mark the zone around this ‘origin’

 

 

Supply and Demand Zone indicators

It’s possible to buy supply and demand indicators that have been custom built for the trading platform. However, drawing supply and demand zones tends to be more of an art than a science and some of the best-known modern supply/demand traders and mentors like Sam Seiden draw the zones using the ‘rectangle tool’ available in most trading platforms, including the FlowBank Pro Trading Platform, which is available on PC, Mac and Mobile devices.

 

Use of oscillators and volume indicators for confirmation

Trading oscillators and volume indicators are essential tools used by traders to confirm trends and potential reversal points in price patterns. They provide an objective measure of the direction and strength of a trend, helping traders identify periods of consolidating and trending.

  • Oscillators are a group of indicators that confine the theoretically infinite range of a market’s price action into more practical limits. They are typically designed to indicate buy or sell signals, providing the trader an idea about the market’s momentum. Examples of popular oscillators include the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD).
  • Volume indicators, on the other hand, are used to determine the strength of a market move. High levels of volume often indicate a strong price move that can be sustained, while low volume levels typically indicate lackluster movements that could reverse.

 

How to differentiate between retest and breakouts

Retests and breakouts are key concepts in trading that can provide lucrative opportunities. However, differentiating between the two is crucial for successful trading.

  • Retests occur when price returns to a former support or resistance level after it has broken through. Traders usually watch for retests as potential entry points with a good risk/reward ratio.
  • Breakouts happen when the price moves above a resistance level or below a support level on heavy volume. Breakouts often signify a significant change in market sentiment.

Understanding the difference between these two can help traders to determine the best timing for their trades and mitigate any potential risks. 

 

Supply and demand trading strategy

Using supply and demand zones as part of a trading strategy means involving other trading methodologies as well as a sound risk management system.

Example: The S/D with 20 DMA Strategy

Here we are using the change in trend shown by the moving average to add extra importance to the demand or supply zone as well as to set the direction of the trade

 

supply demand with moving average

  1. Wait for the price to cross the 20 day moving average
  2. Watch for a long range candlestick in the direction of the MA cross
  3. Mark the Supply / Demand zone from the big price move
  4. Set your entry order at the beginning of the price zone
  5. Set your stop loss past the end of the price zone
  6. Set your take profit order with a 3X risk: reward ratio and/or at a support / resistance level

 

Thanks for reading! To test your supply and demand trading skills, click here register for a free demo trading account from FlowBank

Case Studies: Successful application of supply and demand zones

One of the most effective ways to understand the application of supply and demand zones is through case studies of successful trades. These can provide real-world examples of how these concepts can be used to anticipate market movements and make strategic trading decisions.

Risks associated with trading in and around supply and demand zones

While trading in supply and demand zones can be profitable, it also comes with its fair share of risks. These include:

  • False breakouts: Often, a price will break through a supply or demand zone only to reverse direction. This is often a result of market manipulation or low trading volume.
  • Unexpected news events: Any unforeseen economic or political event can drastically impact price movements, rendering supply and demand zones ineffective.
  • Over-reliance on zones: While supply and demand zones are useful tools, they should not be used in isolation. It's important to use other indicators alongside them to confirm your analysis.

Best practices when trading with supply and demand zones

Here are some best practices for trading with supply and demand zones:

  • Always use stop-loss orders to protect against unexpected market movements.
  • Use other indicators in conjunction with supply and demand zones to confirm your analysis.
  • Always keep an eye on the news for any major economic or political events that could impact the market.
  • Practice patience and discipline. Wait for the price to reach the supply or demand zone and confirm your signals before entering a trade.

 

FAQ

What are the basics of Supply & Demand trading?

Supply & Demand trading revolves around the core principle that price movements in a market are driven by imbalances between buyers (demand) and sellers (supply). When demand exceeds supply, prices tend to rise, and when supply overshadows demand, prices typically fall. In trading, recognizing areas where these imbalances occur (Supply & Demand zones) can provide opportunities for entry and exit points.

How do Supply & Demand zones differ from Support & Resistance?

While both concepts focus on identifying possible reversal or breakout areas, the methods of identifying and using them differ.

 

Supply & Demand Zones are areas where price has changed direction in the past due to an imbalance of buyers and sellers. A supply zone suggests a surplus of sellers pushed prices down, while a demand zone indicates a surplus of buyers drove prices up.

 

Support & Resistance are horizontal levels where the price has historically found it difficult to move below (support) or above (resistance). They emerge from psychological levels, previous highs and lows, or technical patterns, not necessarily from supply and demand imbalances.

Why is the Wyckoff Methodology important in understanding market dynamics?

The Wyckoff Methodology provides a structured framework for interpreting market actions through the lens of supply and demand dynamics. By identifying various phases, like accumulation and distribution, traders can anticipate potential future price movements. Wyckoff's approach emphasizes the importance of understanding the intentions of "smart money" or large institutional players, helping traders align with these dominant forces.

What tools can help in identifying Supply & Demand zones?

Various tools can aid in spotting Supply & Demand zones:

  • Historical price data, such as significant turning points or consolidation areas, can hint at Supply & Demand zones.
  • While primarily for other purposes, oscillators and indicators like RSI or Stochastic can sometimes help validate zones when combined with other methods.
  • Simple horizontal lines, rectangles or other drawing tools on charts can help traders visually mark and track potential zones.

How can traders ensure they're using strong Supply & Demand zones?

To determine the strength of Supply & Demand zones, filter in/out the zones based on the following criteria.

  1. Historical Reactions: Zones that caused significant price reversals in the past are often stronger.
  2. Volume Confirmation: High trading volume at a zone can affirm its significance.
  3. Time Factor Zones that have held strong over extended periods tend to be more robust.
  4. Confluence with Other Tools: Combining zones with other technical tools or fundamental analysis can provide additional confirmation.
  5. Fresh Zones: Zones that haven’t been retested frequently can be more potent, as the initial imbalance may still exist.
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