Supply and Demand Zones
What are supply and demand zones?
These are resistance (supply)and support (demand) in a more prominent form. This goes without saying that supply and demand zones are the stronger versions for resistance and support. While resistance and support usually have retracements, when trading supply and demand zones in forex a trader may anticipate a trend reversal.
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What is the difference between “supply and demand” vs “Resistance and support”
The main differences between trading supply and demand zones compared to resistance and support are:
- the area which supply and demand zones covers tends to be greater than the area covered by support and resistance.
- Support and resistance are easier to break when compared to supply and demand zones.
- Supply and demand zones are where trend tends to reverse, while support and resistance are where trends tend to do a retracement.
- Price often do sharp reversals at supply and demand zones, while moving from support and resistance after failing to break multiple times in a short period.
- Supply zones are where traders wait for price to reach to sell, while demand zones are where traders wait for price to enter a long position (hence the sharp reversal in price and trend reversal). On the other hand, resistance and support areas are more often used as areas to enter (buy or sell) and exit (ie: take profit and stop loss) a trade.
How to know the strength of a supply and demand zone?
When trading supply and demand zones, you can know, or at least estimate, the strength of a supply and demand zone by:
- The Time Frame
- How recent has pice touched (approached) the area
As explained previously in chapter 7: Forex Market structure, structures are created on every time frame. Since supply and demand zones are structures, that means they can be found on every time frame as well. Furthermore, the lower time frames the weaker the structure be hence lower time frame structures are easily broken. As a result, traders mostly pay attention to supply and demand zones on higher time frames, H4 and higher, especially the daily.
Notice after touching the demand zone, price had enough momentum to break above the previous lower high, which is normally a sign of trend reversal.
How recent has price approached the area
As explained above, price tends to do reversals after approaching supply and demand zones because of the mass gathering of traders waiting for price to reach the area to enter their desired trade, as well as other traders closing their currently running trades in profit.
If price approached the area in topic not so long ago, only to be rejected, which then approached the area again shortly after, means that there are not enough traders in the area to cause a trend reversal.
For a better explanation, an example would be price being in an uptrend, which means the bulls (buyers) are in control of the market. Approaching supply zones, the bears (sellers) attempted to take control over the market by pushing price down. Price approaching that area for the second (third, fourth, and so on) time means that the bears (sellers) failed to overpower the bulls (buyers).
The multiple failed attempts to take control of the market means that the bulls are stronger than the bears, as a result, there’s a greater probability that price will go in the direction of the bulls (ie: the ones with the stronger force)
What happens when a supply and demand zone is broken?
Again, referring to chapter 7: Market structure, which explained that when a structure is broken, the role of that structure is reversed. One of the reasons why supply and demand zones are harder to break compared to resistance and support is because traders who have running trades tend to close their trades before reaching the area.
Understanding What happens when a supply or demand zone is broken
Before further explanation, a good analogy for better understanding is if you look at a “supply and demand for an asset” as pressure on a gas pedal and the supply zone as a wall. (will be using an uptrend for this example)
The more traders enter buy positions, the more pressure is added to that gas pedal (increase in demand).
The more pressure added to the pedal, the faster the car moves (pushing price further up).
Price approaching a strong structure (resistance = supply zone), with the strong possibility of price changing trend in mind, traders will be opted to secure their profits by closing their buy trades.
After traders closed their buy positions which are running in profit, the pressure on the gas pedal is then decreased.
The closer price gets to the area, the less pressure it has, and if there’s no pressure on the gas pedal, the car (price) is not moving with much force, thus leading to its inability to break the wall (supply zone)
What happens after a supply or demand zone was broken?
Back to the topic of knowing what happens when a supply and demand zone is broken; Sellers who entered a trade that failed to go in their direction would be prompted to closed that sell trade. And since the opposing force that is trying to stop price from going higher has gotten weaker, this indirectly adds more power to the buyers, thus pushes price further up. To be precise, the supply zone became a demand zone.
How to find supply and demand zones in forex?
To find a supply or demand zone:
- traders look at the higher time frames such as H4 or D1.
- Study the chart until you notice the areas where price makes a sharp reversal after approaching that area.
- Use a rectangle tool (available on tradingview and Metatrader) and highlight these areas as illustrated in the picture above.
Traders tend to use a single horizontal line to highlight support and resistance hence where the misconception came from support and resistance are a single price in the chart.
However, using a color-coded rectangle to highlight supply and demand zones gives a visual emphasis on the area to showcase its importance compared to multiple single lines on the chart.
How to trade supply and demand zones in forex?
The practices to trade supply and demand zone are:
- Setting your take profit below a supply zone, and above a demand zone.
- If buying near a demand zone, then the ideal place for the stop loss would be below the demand zone, while on the other hand, if selling near a supply zone, the best place for the stop loss would be above the supply zone.
- Use an oscillator indicator to determine if the price is over-bought or over-sold when at the area. (example: stochastic oscillator) This is not mandatory, but it is a plus.
- Avoid entering trades that are less than 50 pips away from the area.
- Manage your open trades with a possible trend reversal in mind.