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 & demand zones?
- Wykoff and Market Structure
- Types of Supply and Demand patterns
- Understanding the role of liquidity in supply and demand zones
- How to draw a supply / demand zone
- Significance of time frames in supply & demand zones
- Identifying strong supply & demand zones
- Supply & Demands Zone indicators
- Use of oscillators and volume indicators for confirmation
- How to differentiate between retest and breakouts
- An example S/D Zone Trading Strategy
- Case Studies: Successful application of supply and demand zones
- Risks associated with trading in and around supply and demand zones
- Best practices when trading with supply and 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 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.
Wykoff & Market Structure
Let’s think about the three simplest concepts in trading financial markets
- When demand is greater than supply, the price goes up
- When demand is equal to supply, the price goes sideways
- 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.
- Accumulation
- Markup
- Distribution
- Markdown
They can be seen in Wykoff’s classic schematic of 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
S&D Continuation patterns
The Rally-Base-Rally is a bullish continuation pattern
The Drop-Base-Rally is a bearish continuation pattern
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.
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.
- From a base
- 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.
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.
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:
- 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.
- 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.
- 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.
- 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.
- 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.
Source: 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
- Wait for the price to cross the 20 day moving average
- Watch for a long range candlestick in the direction of the MA cross
- Mark the Supply / Demand zone from the big price move
- Set your entry order at the beginning of the price zone
- Set your stop loss past the end of the price zone
- 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. (Suggest to show case studies where supply and demand zones have been successfully applied)
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.
