Price Action Trading Strategy: Supply & Demand Zones

The law of supply and demand governs all market prices. Supply & demand zones put the economic theory into a trading strategy using price charts. Read on to learn more about S&D trading...

Contents: Supply & Demand Zones

  • What are supply & demand zones?
  • Wykoff and Market Structure
  • Types of Supply and Demand patterns
  • How to draw a supply / demand zone
  • Identifying strong supply & demand zones
  • Supply & Demands Zone indicators
  • An example S/D Zone Trading Strategy

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.

What are zones in trading?

You can skip ahead to see how to draw the supply and demand zones for day trading strategies BUT we’d recommend a quick background on the investment theory to give you confidence in why this trading strategy works first…

What is a supply zone?

The candlesticks or bars that mark the origin of a strong downtrend are called the supply zone or distribution zone.

What is a demand zone?

The candlesticks or bars that mark the origin of a strong uptrend are called the demand zone or accumulation zone.

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.

Types of supply and demand patterns

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.

S&D Reversal Patterns

The Drop-Base-Rally is a bullish reversal pattern

The Rally-Base-Drop is a bearish reversal pattern

supply demand reversal patterns

S&D Continuation patterns

The Rally-Base-Rally is a bullish continuation pattern

The Drop-Base-Rally is a bearish continuation pattern

supply demand continuation patterns

This is important because 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.

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’

 

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

 

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.

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.

Supply and demand vs Support and Resistance

Supply and demand zones are typically drawn close to support and resistance levels (S&R levels) but are not quite the same.

Support is drawn at the low of a candlestick that has had at least two candlesticks with higher lows on either side.

Resistance is drawn at the high of a candlestick that has at least two candlesticks with lower highs on either side.

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

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