You may hear the term “supply and demand” in forex trading.
They are the most essential factor for both technical and fundamental analysis.
But what are supply and demand zones?
Let’s explain each one of them in detail, how you can identify them, and how you can trade with supply and demand zones.
1. Supply zones
A supply zone is a pricing area above the current price where there is a lot of selling. When the price reaches this level, the orders are satisfied, and the price falls.
When prices are higher, suppliers want to sell more since selling more quantity at a higher price results in bigger profits. Conversely, when prices are lower, suppliers are not driven to increase output because profitability is low.
Simply said, the law of supply zones examines the link between quantity and price from the seller’s perspective. As a result, there is a linear relationship because the more the price rises, the more supply there is.
As shown in the chart above, price climbs to a certain level or zone, pauses for a short period, and retraces back down. As long as there are unfulfilled orders, the price will return to this supply zone until all orders are completed.
2. Demand zones
A demand zone is a price range below the present price where there is a high level of buying interest. We can notice a lot of buying interest in the demand zone on the chart below. This is most likely due to a large number of factors.
If the price swings higher, leaving a portion of these buy orders unfilled, they will most likely be kept untouched, waiting for the price to return and trade through them once more.
When this occurs, the massive demand overload is expected to push prices further higher.
How do you determine supply and demand zones?
It’s great that you know what supply and demand zones are, but how can you identify them on the charts?
We must first discover market imbalances to find supply and demand zones. These are large price swings in either direction (up or down) due to supply and demand.
We sought up and left the present price to discover powerful bearish candles with huge bodies to appropriately identify a supply zone.
The chart below depicts the price’s departure from the base. Starting from the left side of the chart, the price climbed a little and paused for a little period, forming a lovely three-candle base structure. The price then plummeted, forming long bearish candles and demonstrating a significant market imbalance around this supply zone.
As the price continues to retrace back up to this supply zone, we can use this retracement to create trades around the base area. Take note of how the price retraces up and drops as it approaches the supply zone.
As a result, massive amounts of unfilled orders are piled up around this supply zone.
The basic structure is critical for properly selecting the optimal supply zone to construct your lines. To be regarded as an excellent trading base structure, we should select a base with fewer than six candles.
To locate a demand zone, we need to find a nice price rally or a group of bullish candles and a base with less than six candles. The chart below shows how the price plummeted, stalled for a short period, building a consolidation structure, and then rose up from the base with very long bullish candles, forming a demand zone.
Pro Tip: By zooming out, you can obtain a clearer look at areas where the price has previously bounced off. When switching between several time frames, make sure to use the relevant charts.
Supply and demand zones trading strategies
Besides pinpointing supply and demand zones on the chart, you can use them in other strategies also.
Here are the two popular supply and demand zones trading strategies:
Range trading strategy
If supply and demand zones are well established, they can be employed for range trading. You can use a stochastic indicator or the RSI to help you detect overbought and oversold positions.
Breakout strategy
Another supply and demand trading method is the breakout strategy. Price cannot remain inside a fixed range indefinitely and will eventually fluctuate in one direction or the other. You seek a favourable entry into the market in the breakout direction, as this might be the beginning of a powerful trend.
Do supply and demand zones work?
You may now wonder, “Does supply and demand trading work?”, “Is supply and demand trading profitable?” or “Is supply and demand trading a viable strategy?”
Yes, supply and demand trading strategies are profitable. Trading with supply and demand zones is effective.
However, keep in mind that the supply and demand notion is more of an explanation than a strategy. You can’t use present observable supply and demand zones to forecast future supply and demand zones.
As a result, you must thoroughly understand how supply and demand zones operate. You must identify high-quality supply and demand trading zones that are both reliable and possibly profitable to trade. Otherwise, you will most likely lose.
Key takeaways
- When there is a lot of buying pressure, the price goes up (demand).
- When there is a lot of selling pressure, the price drops (supply).
- In forex, supply and demand zones are areas where price activity is likely to reverse.
- You buy when the price bounces upwards from a demand area. Place a stop loss below the zone.
- You sell when the price bounces downwards from a supply area. Place a stop above the zone.
Bottom line
Supply and demand are at the heart of what trading is all about; therefore, it’s no surprise that they may serve as the foundation of an effective trading strategy.
Understanding what supply and demand are, how it works, and what drives price activity in these zones is the first step in trading supply and demand.