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How To Trade Supply And Demand Zones

The difference between supply and demand, and support and resistance may seem small, but a trader who understands the implications of supply and demand can develop his trading edge beyond his expectations. I use supply and demand in my own trading strategy to find better trades and you can learn even more about in our Forex course.

Supply and demand is a concept that analyses how financial markets move. On every price chart, there are price points and areas where the shifting balances between buyers and sellers are obvious and jump right at you – those are usually supply and demand areas. The attentive observer can easily spot those price areas and use it to his advantage while the amateur often fails to understand this fundamental price principle.

 

Order absorption – why common trading knowledge is wrong

The scenario below is something we all have seen hundreds of times. It shows the classic price behavior around a support level. Common trading wisdom tells you that with each touch of a price level, the support area becomes stronger. This couldn’t be further from the truth.

What makes price go down is an imbalance between buyers and sellers and there is more selling activity than buying going on. And when price reaches the support level, buyers enter the market again and outnumber the sellers. Then, price goes up until sellers become interested again and drive price down. This is a very basic view but it explains how markets move.

But each time price makes it to the support level, there will be less and less buyers waiting because, at one point, all buyers who were interested in buying have executed their trades. This is called order absorption. The screenshot shows that price bounced less high with each “touch” and eventually it broke the support level.

When everyone has bought and when there are no buyers left, the support level will break and price falls until it reaches a price level where buyers will get interested again.

 

supp

 

Think of order absorption around a price level like a ball that bounces off the floor. Each time the ball hits the ground, some of the energy is absorbed by the floor. Thus, each consecutive bounce will be lower than the previous one until all energy is gone and the ball comes to a standstill.

Bounce_lower

Trading books teach you that a support/resistance level becomes stronger the more touches it has. This is not true and a reason why traders struggle.

 

Identifying high probability supply and demand zones

Now let’s take a look at some charts and see how we can apply our knowledge to find trading opportunities.

The highest probability price levels are the ones with the greatest imbalance between buyers and sellers. What does that mean? Whenever you see a rally and then suddenly, without any prior warning, it reverses on the spot and drops like a stone – those are the areas of major imbalances.

The highest probability price levels are the ones with the greatest imbalance between buyers and sellers.

1

 

Think about it from a neutral perspective. What does it tell you about price when you see a rally and then all of a sudden price reverses in one candle and starts a strong sell-off? Exactly. The amount of sellers who have entered the market at that price outnumbered buyers in such a fashion that price wasn’t able to withstand it. It takes a lot of sell orders to stop a trend and even reverse it.

But this is not only hindsight market analysis; you can use this knowledge to make assumptions about future price movements too. Whenever you see such a price area it is –reasonably – safe to assume that not all sellers were able to enter at that price on the first sell-off. We have all seen it before: during a high impact news event price just ran away and we weren’t able to get a fill – this is what happens as those runaway supply and demand zones too.

Furthermore, it is also very likely that, in case of a sudden sell-off, more sellers were waiting to sell just above that level. If price fell from $50.00, it is very likely that other traders were willing to sell at $51 too – who wouldn’t like to sell for a higher price? This is a trading concept called “trading the white space” and although it can be challenging to wrap your head around it when you hear about it the first time, it helps traders understand markets in a new way.

3

 

“Trading the white space” means that price picks up unfilled orders and squeezes traders on the wrong side of a market.

4

 

 

 

Chart example – supply and demand imbalances

There are three things in particular that we look for when identifying high probability price areas:

1) A strong trending move prior to the reversal

2) The strong reversal itself. Price reverses immediately and does not stay at the level

 

Always wait for the squeeze

Don’t let supply and demand trading turn into predicting tops and bottoms. Waiting for a confirmed squeeze and entering AFTER price has already reversed is they key to supply and demand trading. It is also the hardest lesson to learn.

3) A strong trend into the opposite direction.

 

The chart below shows 6 price points that qualify as high probability price areas. All of those 6 areas show great imbalances between buyers and sellers and a sudden shift in direction. The turning points marked with numbers are initial price imbalances between buyers and sellers. The trading opportunities exist when price moves back into those areas – the areas marked with green checkmarks.

 

6

 

The first point was a major swing high after a rally. Price reversed with just one pinbar and dropped afterwards. When it came back to the level the second time, it did not immediately reverse but it sold off eventually. Sometimes the accumulation can take a while, but as long as price does not violate the level, it remains valid.

The second point was a pullback during a downtrend. The bullish pullback was a strong one with 3 large bullish candles. Still, price reversed in a strong fashion and continued its downtrend afterwards. The next time price came back it sold off again.

The third point was a price bottom. After a long downtrend, price bounced strong and the next time price came back, it found buying support again. And it goes on like this forever…

Just pull up any price chart and try to find those areas when the trend immediately reversed. The stronger the rejection of the level and the stronger the trending moves before and after the reversal, the higher the likelihood that you will see a new reaction the next time price comes back.

 

Some anti-examples

The best supply and demand zones with the greatest imbalance between buyers and sellers are very obvious and they should jump at you when looking at a chart. If you have to think about a setup and wonder if it really qualifies as a high probability area, it probably isn’t one. This is true for all trading methods and types of setups.

The screenshot below shows 4 points where many traders would have ran into problems. But they either lack a strong reversal pattern or do not have a strong enough follow-through after the reversal itself.

 

not like this

 

A timeless market pattern

You can find this pattern on all markets, asset classes and timeframes because it is the manifestation of the interaction of buyers and sellers. Of course, the pattern won’t work all the time, but it provides enough information about orderflow that it enables traders to find high probability price levels.

Especially in the case of Forex majors or stocks with a high market capitalization, it requires a significant imbalance between buyers and sellers to let a market reverse immediately.

To take your trading to the next level, check out our Forex trading course where you’ll learn my whole trading system.

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14 comments

  1. Hi Rolf & Moritz: Thanks for a number of great articles. It is particularly pleasing to see comments about “WHAT NOT TO DO”, I have only ever seen articles saying HOW TO DO IT, but how do you avoid the pitfalls if you are not even aware of them.
    Cheers Peter

    • Hello Peter,

      thanks for taking the time to leave a comment. Indeed, looking at what not to do can help people understand the concepts in a different and deeper way.

      Rolf

  2. Your statement from above seems back to front to me”And when price reaches the support level, buyers enter the market again and outnumber the sellers.” Surely that should read SELLERS ENTER THE MARKET AGAIN!!
    Cheers Peter

    • Hello Peter,

      at a support level, you get a bounce to the upside which is driven by a buyer surplus. I hope that makes sense.

      Regards
      Rolf

      • I will have to keep reading some more – my understanding is that at a Supply level is where the Sellers come in & push price down.
        Cheers Peter
        p.s What are the settings for the SMA you use?

  3. Hi Rolf: In your video on Supply & Demand trading it appears to me that you are saying to wait for a confirmation candle BEFORE placing a trade. If that is correct do you explain anywhere on how to calculate Stop Loss & Lot size along with the TP using this method. With normal S & D trading you have the zones to work off for both SL & TP but how would this work on a second candle which could be an extreme distance from the outer edge of the S or D hence in the case of the SL decreasing your lot size considerably.
    Looking forward to your comments – Cheers Peter

    • Hi Peter,

      good question. I will answer this step by step once we relaunch Tradeciety. We are preparing a lot of new material where we discuss every part of the strategy.
      It’ll be available in 2-3 weeks probably.

      Rolf

  4. Hi Rolf: How do you find a Supply zone in the instance of say the AUDCAD H1 19/01/17 ?
    I have found many instances of this type of problem today.
    Cheers Peter

  5. Excellent lesson, thank you. I don’t know guys how you do it but you make things really easy to understand (like the advice to look for a sharp move and then where it initiated from to find the supply/demand area – so easy to spot it that way).

  6. Love the example of the ball bouncing but would think that if it was bouncing on a Table then got to the end and fell off towards the floor that would be a better example of how Support is eventually broken.

    1973Hog

  7. hi Rolf
    thanks a lot.article a good

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