Professional Documents
Culture Documents
Supply and Demand Good Book
Supply and Demand Good Book
17 min read
By far, one of the most common questions I get these days is how to trade supply and
demand.
Even though the concept is essential to how free markets operate, it has gotten a lot
more popular as the basis for trading strategies in recent years.
And it makes sense! Using supply and demand as a part of your trading arsenal can be
quite effective and potentially very profitable. So let’s figure out how to use supply and
demand in your trading.
Imagine the following scenario: if the price of EURUSD increases, there will be more
people willing to sell because it will make them more money, right? This is the law of
supply: the higher the price, the higher the quantity that is supplied.
Now, imagine the scenario from the point of view of the buyers. Whenever something
becomes cheaper, you will be more interested in buying, right? On the other hand, if the
price increases, you’ll be less and less interested in getting it. This is the law of
demand: the higher the price, the lower the quantity demanded.
Privacy - Terms
Privacy - Terms
Let’s go over this example. At ①, we can see that there is a small area with Doji candles.
The price doesn’t seem to move a lot because essentially, supply equals demand. This
changes at ② because there is more supply than demand, driving the price sharply
lower. At ③, we see some stability again where roughly, supply equals demand, forcing
prices to stay the same.
At ④, we see that the price breaks out from this area again and starts rallying. There is
more demand than supply here, meaning the buyers are in control. At ⑤, this dynamic
changes again and we see a lot of sideways consolidation but eventually at ⑥, the
sellers step in and move the price lower.
The price takes a breather at ⑦, meaning that there again is a supply-demand
equilibrium, before pushing the price further down at ⑧. At this point, there is more
supply than demand.
Supply And Demand Zones
Given what we discussed before, we can view any chart as a sequence of zones where
there is supply and demand equilibrium with supply and demand imbalances in
between.
Privacy - Terms
Let’s focus on these zones in particular. Especially, the zones where the price is
moving away from with a lot of momentum are interesting to us because whenever
that happens, it’s a sign that the balance of supply and demand has shifted in a very
substantial way.
Supply and demand zones are the origins of these price moves.
We can also use the following narrow definitions:
A supply zone is a horizontal price area at which a lot of sudden selling has
occurred. This resulted in an imbalance between supply and demand, where supply
greatly exceeded demand, pushing the price down.
A demand zone is a horizontal price area at which a lot of sudden buying has
occurred. This resulted in an imbalance between supply and demand, where
demand greatly exceeded supply, pushing the price up.
g y pp y, p g p p
Privacy - Terms
We can see how the supply zone shows a narrow consolidation (= supply and demand
equilibrium) and all of a sudden, the price shoots out to the downside with a lot of
momentum.
We can also see a demand zone with again, a narrow consolidation, from which a strong
move up happens.
Here, we can see another example of an area of consolidation and the price moving
strongly away from it with a lot of momentum:
Privacy - Terms
Privacy - Terms
Another difference is that supply and demand is often a leading indicator. While
traditionally, support and resistance levels are only called as such after at least two
tests, this is not the case with supply and demand. You only need a supply or demand
zone to be created in order to plan a potential trade.
Eventually, what works best is if you can use both concepts together. One is not better
than the other but both have benefits and drawbacks.
Privacy - Terms
The first type of supply and demand pattern is called rally – base – drop. It happens
when we see a rally to a certain zone, followed by a short consolidation and then a
strong bearish move away from this zone again (the drop).
In this supply pattern, we’re looking for supply areas that we can see a strong bearish
move away from. Here’s a chart example:
Privacy - Terms
In this demand pattern, we’re looking for demand areas inside a trending market, from
where we can see a strong bullish move from. Here’s an actual chart example:
Privacy - Terms
Privacy - Terms
In this supply pattern, we’re looking for supply areas inside of a bearish downtrend,
from where the price continues down in a strong way. Here’s an actual chart example:
Privacy - Terms
On this chart, we can see in four different occasions that the price made a strong move
with successive candles in one direction.
Both the momentum (how fast is the price moving) and the absolute distance (for far
did the price move before it stopped going in that direction) are relevant here. Of
course, the best price moves show both momentum and a large absolute distance.
Trend Considerations
Another thing that plays a role is the overall trend direction. The best demand levels
often happen after the price has been in a long downtrend, while the best supply levels
often happen after the price has been in a long uptrend.
Why is that? The easiest analogy would be to think of the trend as a train in motion. The
y gy
faster the train goes, the more force is necessary to make the train stop and reverse,
right?
So if the price is in an uptrend, it will take much more sellers to make the price drop
back down in the opposite direction. Conversely, when the price is in a downtrend, it will
take much more buyers to make that downtrend stop and reverse. Let’s understand this
with an example: Privacy - Terms
In the above chart, we can see a tight consolidation, after which the price sells off
strongly. While this looks like any other good supply zone, we should also consider the
overall trend direction:
Privacy - Terms
See how this supply zone was created in a downtrend? Given that the overall trend was
down, it would require fewer sellers to push the price lower because everyone was
looking for shorts already.
When we look at the extension of this supply zone, we see how it didn’t hold on the way
back up and instead, the price just moved through it without too many problems:
Privacy - Terms
Because it’s exactly this area that is responsible for the resulting move:
The base of a supply or demand zone is where the orders were placed that were
pp y p
responsible for moving the market in such a strong way.
Let’s apply this knowledge to our chart:
Privacy - Terms
As you can see, I’ve marked the base for each of the strong moves we identified on the
chart.
Privacy - Terms
When there is a tight consolidation period before the momentum drive, it makes sense
to use the upper and lower boundaries of that consolidation as the base, regardless of
whether this includes wicks or not. After all, that is where the orders were created
before the momentum drive:
Privacy - Terms
Privacy - Terms
In the above chart, we can see how the upper boundary of the demand zone can be
made narrower since it lines up pretty nicely with previous support and a swing high
spike. It ended up being pretty perfect demand area, as the price just briefly dipped in
the area and then shot up again.
Privacy - Terms
By now, you might also have noticed that something else happened: with almost every
one of our supply or demand zones, the price eventually revisited that area and, for the
second time, moved away in a strong fashion. Which brings us to the next point.
Privacy - Terms
We can see how the price shoots up from a narrow consolidation on the left of the
chart, creating a demand area. When the price eventually returns to this zone, we can
see a quick dip into the demand area, after which the price moves up again.
Before we go on, I want to talk a bit about WHY this happens. After all, any supply and
demand strategy can make much more sense if you don’t just understand how but also
why. And this is where liquidity comes in.
Liquidity Patterns
In order to understand why supply and demand zones can work as the basis of a trading
y pp y g
strategy, we need to look at how buyers and sellers behave around these zones. A lot of
this comes down to finding liquidity.
Liquidity describes how easily an asset can be bought or sold.
Privacy - Terms
When there is a lot of liquidity, we say that the orders can easily be absorbed by the
markets. It means that there are many traders willing to take the other side of your
order.
When there is little liquidity, it might be harder to get your orders filled. Because there
might not be enough traders to take the other side of your trade at the price you want,
you might get filled at a worse price than expected. The risk you assume is called
market liquidity risk. Another common symptom of illiquid markets is that they have a
bigger spread.
It also makes sense that the bigger your orders are, the more liquidity might be an
issue. This is why some institutional traders use special techniques to get a good price
for their order.
Order Slicing
Whenever institutional traders need to open a position, they do so with much larger size
than the average retail trader. In fact, their positions are usually so big that if they were
to simply enter at once, they would move the market considerably.
So what do they do? Many of them will employ something called order slicing, where
they split up their single order into multiple parts and only execute those in the market
once enough liquidity is available.
Privacy - Terms
Privacy - Terms
Let’s take the next chart as an example. The institutional trader is looking for enough
liquidity to get a fill on his big order. He wants to go long but so he needs to find traders
who want to sell their position to him.
Below the swing low, there will be lots of that liquidity: first, you will have the stop
losses of buy orders, which will sell on the market once they’re hit. Additionally, there
will also be traders who go short, again adding liquidity to the market.
This is why you will often first see a spike in the opposite direction at the origin of a
strong price move. The Liquidity Spike is the pattern that gets created when large
market participants need liquidity and move the market in order to get it.
Retail traders get trapped, their stops get hit and they will often talk about “stop
hunting” while in fact, this is nothing more than normal market behavior.
Privacy - Terms
Using the previous chapter on liquidity, we understand what is creating both the
consolidations and the momentum drives that creates supply and demand zones. But
why is the price bouncing from our zones when returning to those same zones?
Reason 1: Institutional buying and selling
If there was an institutional trader (either a bank or hedge fund or anything else) who
made the price move so strongly that it created a supply or demand zone, what really
happened is that the liquidity around that price dried up.
This means that there wasn’t anyone left taking the other side of the position and this
made the price move in a very strong way. However, it’s very likely that this institution
also wanted to take a bigger position than it actually could. So what happens when the
price returns to the level they were initially taking a position?
That’s right, they get in the market for a second time. In turn, this moves the market
again, which is what drives the supply and demand bounce.
Reason 2: A Perfect Profit Taking Area
Privacy - Terms
As we discussed earlier, the price always moves from one supply/demand balance to
the next supply/demand balance. This means that for every trader that is waiting to
enter at the supply or demand zone bounce, there’s another trader that is already in a
position and dying to find a good spot to take profits.
So guess where they are looking to take profits? Exactly, the same supply and demand
levels that we are looking at!
Imagine for a second the following demand zone. We could see the price briefly dipping
lower and then shooting up. Then on the return, we could see the price bouncing
strongly back up again:
Privacy - Terms
That was a 1H chart. Now look at the same instrument on the 8H charts. Imagine that at
this demand zone, someone took a short on the 8H. Immediately, the price turns the
wrong way and the trader is at a loss.
What happens is that whenever the price comes back to the entry, it gives the trader an
opportunity to get out of what he thinks is a bad trade, for a break-even result. That was
close!
Privacy - Terms
Of course, when all these traders are covering shorts, it means that a lot of buy orders
are flooding the market, again pushing the price back up.
The Myth of Pending Orders from Institutional Traders
I often read that the reason that supply and demand zones show a reaction on the
retest is because of pending orders of institutional players. While it is true that
institutional positioning drives price action around these levels, it simply doesn’t happen
with pending orders.
The question you need to ask is: why would they want to do this instead of just using
market orders? There is zero benefit in doing so and limit orders give the institutional
traders at least two disadvantages:
1) it gives away their positioning for no good reason
Whenever a trader creates a pending order, this shows up in the order book. In most
cases, those add liquidity to the market. It also gives an indication to other traders about
how they are positioned, which is not necessary and doesn’t happen if they simply use a
market order.
Privacy - Terms
2) they don’t yet know what size could be absorbed by the market
Imagine that you have a really big order. As we discussed previously, the institutional
traders will use specific techniques to make sure the price doesn’t move too much when
these orders enter the market.
However, they don’t yet know how much liquidity will be available in the market around
those zones so it doesn’t make sense to add pending orders yet. Any institutional trader
will first need to observe the order book to see what size he could put on around these
zones. Using pending orders would simply pose a risk that the market moves away too
much.
1. Immediate Entry
The first way to trade supply and demand is to use an immediate entry, meaning that
you just place an order in the supply or demand zone and whenever that order is filled,
you’re in a trade.
Privacy - Terms
The benefits of this is that it’s less likely you’ll miss a trade because you can create a
pending order beforehand. The drawback is that you might risk that the level doesn’t
hold at all and instead end up with a loss. however, if you have defined quality supply
and demand zones, this will still work very well.
Here’s an example of how you can enter at the close of an inside bar at the supply zone:
Privacy - Terms
An indicator such as ATR can give you an insight into how volatile an instrument is and
as such, can help you with determining how wide your stop loss should be. For example,
we could choose to use a stop loss that is twice the 24-period ATR of the entry candle:
Conclusion
Supply and demand is at the core of what trading is all about, so it’s not surprising that it
can form the basis of a powerful trading strategy.
The first step in trading supply and demand is understanding what it is, how it works
and what drives price action around these zones. While only introductory, the aim of
this article was to shed some light on this and I hope you found it helpful.
S l dd di il i h b k ld b i b h i
Supply and demand is easily so extensive that a book could be written about the topic.
However, it’s also important to prevent misinformation from spreading so
understanding the basics of supply and demand is where everything starts.
The next step for you should be to go out and look at charts. Identify the supply and
demand areas and see how the price behaves around these areas. Observe, make notes
and build your experience. Privacy - Terms
If you want me to write more about supply and demand and how to trade it, please
leave me a comment on this article. Or if you simply enjoyed my article, feel free to let
me know as well 😉
Good luck in the markets!
SFL (HTTPS://SMARTFOREXLEARNING.COM/AUTHOR/SFL/)
FX and futures trader, using price action, market profile and order flow to trade markets.
I also have an interest in trading psychology and algorithmic trading. Follow me on
Twitter: @GhostwireTrader (https://twitter.com/GhostwireTrader)
Sponsored
A Marine rushes home to greet his wife, but is surprised when he sees her.
Tips and Tricks
Couple Divorced During Wedding Night Because Groom Makes A Shocking Discovery
House Coast
The World's Best Gymnast, Nadia Comaneci Today
FoodIsInTheHouse
Privacy - Terms
Name
Ajay
Ajay − ⚑
3 years ago
🙏🙏
It's been said that, getting information is easier than ever, but filtering information is tougher than ever...
And I really appreciate you, for doing the tougher work
6△ ▽ Reply
smartforexlearning > Ajay − ⚑
🙏
3 years ago
Privacy - Terms
Hey Ajay, glad you like it!
1△ ▽ Reply
Ikechukwu Odume − ⚑
3 years ago
Thank you so so much for this detailed explanation. It's so much eye opening for me.
5△ ▽ Reply
smartforexlearning > Ikechukwu Odume − ⚑
3 years ago
△ ▽ Reply
Viral Bhuptani − ⚑
3 years ago
I really loved this article. I have learnt about S/D trading from Sam Seiden.
I just wanted to know that "Another thing that plays a role is the overall trend direction. The best demand
levels often happen after the price has been in a long downtrend, while the best supply levels often happen
after the price has been in a long uptrend."
Do you mean to say that best levels re DBR and RBD
4△ ▽ Reply
smartforexlearning > Viral Bhuptani − ⚑
3 years ago
Hi Viral, thanks for your kind words! And in a literal sense, then yes, this will only happen with DBR and
RBD patterns.
But even with DBD and RBR, you might find that it can either be opposing or in line with the overall trend.
Take ⛺ View — disq.us for example, you could assume that the overall trend direction before this RBR
😊
pattern was bearish (i.e. the price was in a larger downtrend) and then the trend direction guideline still
applies
△ ▽ Reply
Viral Bhuptani > smartforexlearning − ⚑
3 years ago
Thanks for the reply
If the overall trend is in the downward direction, wouldn’t it make sense to not trade at that zone or
book profits if you are already in a short position. It may give a nice bearish flag but not a good
Reward and we may only look to short it at a good supply zone.
△ ▽ Reply
△ ▽ Reply
smartforexlearning > Viral Bhuptani − ⚑
3 years ago edited
Of course, this should only be done when the momentum drive is strong enough. While you could say
this is counter-trend, you could also argue that if institutional traders managed to to push the price up
so strongly, regardless of the downwards trend, then it's strong enough to push the price back up
once it revisits this area again. This is the "stopping train" concept I talked about.
Privacy - Terms
But of course, it's much easier to do with a DBR or RBD as you are literally at the lows or highs of a
certain move.
△ ▽ Reply
Viral Bhuptani > smartforexlearning − ⚑
3 years ago
What's "stopping train" concept? A trader that I follow recommended your article on twitter and so I
really don't know about your concepts. But, I would surely go through the articles on your website and
recommend it to fellow traders.
1△ ▽ Reply
smartforexlearning > Viral Bhuptani − ⚑
3 years ago
Search for "train" in this article:
> The easiest analogy would be to think of the trend as a train in motion. The faster the train goes,
the more force is necessary to make the train stop and reverse, right?
> So if the price is in an uptrend, it will take much more sellers to make the price drop back down in
the opposite direction. Conversely, when the price is in a downtrend, it will take much more buyers to
make that downtrend stop and reverse.
3△ ▽ Reply
Viral Bhuptani > smartforexlearning − ⚑
3 years ago
Got it, will surely go through the article as well.
Thank you for clearing all the doubts.
God bless you.
△ ▽ Reply
🙏
3 years ago
Hey Asani, thanks for your kind words! I haven't written a follow-up article on this for now. However, I
do use those techniques in my Trade Advisor program so that could be an option if you're interested in
learning how to trade this: https://smartforexlearning....
△ ▽ Reply
😄
a year ago
Glad you like it, Elisabeth!
△ ▽ Reply
This comment was deleted.
−
Avatar Privacy - Terms
🙏
3 years ago
Abiramo − ⚑
6 months ago
△ ▽ Reply
smartforexlearning > m kh − ⚑
6 months ago
I don't have an indicator for trading supply and demand. I trade it by interpreting charts, eventually
building up the experience needed to trade it properly.
△ ▽ Reply
Privacy - Terms
Search…
ABOUT
FX and futures trader, using price action, market profile and order flow to trade markets. I also
have an interest in trading psychology and algorithmic trading.
I only send out an email if I believe it would genuinely benefit you. It's that simple.
Email address:
SIGN UP
Trading Futures, Forex, CFDs and Stocks involve a risk of loss. Please consider carefully if such trading is appropriate for you.
Past performance is not indicative of future results. Articles and content on this website are for entertainment purposes only
and do not constitute investment recommendations or advice. CFDs are complex instruments and come with a high risk of
losing money rapidly due to leverage. 76.5% of retail investor accounts lose money when trading CFDs with this provider. You
should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your
money.