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 the price go down is an imbalance between buyers and sellers and there is more selling activity than buying going on. And when the price reaches the support level, buyers enter the market again and outnumber the sellers. Then, the price goes up until sellers become interested again and drive the 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 fewer 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.
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.
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.
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 number 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.
“Trading the white space” means that price picks up unfilled orders and squeezes traders on the wrong side of a market.
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
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 in 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.
The first point was a major swing high after a rally. Price reversed with just one pinbar and dropped afterward. 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 afterward. 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.
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.
A timeless market pattern
You can find this pattern in 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 order flow 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.