Supply and Demand Zones - How to Spot Them Properly

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To Identify Supply and Demand Zones:

  • Look for areas on the chart where price reacted strongly on multiple occasions.

  • Supply Zones - areas where price rose rapidly and then dropped sharply.

  • Demand Zones – areas where price dropped and then bounced back up quickly.

  • Use volume to confirm - high volume on reactions indicates stronger zones.

The supply and demand laws ultimately control all marketplaces. When discussing trading in the market, most traders depend on technical indicators to identify imbalances in supply and demand.

However, others watch supply-demand trends and zones to formulate a trading strategy governed by economic theory.

Banks and other similar institutions create these zones, which are actually price levels where unfulfilled orders wait to be completed. To win over the whole concept of supply and demand, traders need to find smart money orders on the price chart. Moreover, they also need to identify the supply-demand zone correctly.

In this article, you will learn step by step what supply and demand zones are and how you can better identify them on a price chart.

  • What characteristics define a strong supply or demand zone?

    Thin zones instead of wide ranges, previous strong reactions from the zone, validating price action patterns.

  • Do zones ever stop working once formed?

    Yes, zones can lose their power if price moves past them significantly or if a fundamental change alters the supply/demand equilibrium. Volatile news events can rapidly shift supply and demand dynamics, causing zones to fail.

  • Can old supply zones turn into demand zones later on?

    Absolutely, former supply can become future demand if market dynamics shift, and vice versa.

  • Do zones work on all time frames and assets?

    Zones work very well across forex, crypto, stocks, futures, and other liquid markets on the hourly chart and higher.

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What Are Supply and Demand Zones?

Before we jump directly on learning how to identify the supply-demand zone on a price chart, you need to understand these concepts fully. So let's learn about each zone before moving forward.

Supply Zone

A supply zone is a price level area at which the traders usually sell. This area is present above the current price, where the highest selling interest or potential lies.

When the price hits a recognized supply price level, the unfilled sell orders get completed and, thus, usually bring down the price. Take the help from the chart below to understand the supply zone concept more clearly.

supply zone

supply zone

The above chart shows the price reaching a specific price zone (the shaded area), and then going back down. This cycle will keep repeating itself until all unfulfilled sell orders get filled.

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Demand Zone

A demand zone is a price level area at which traders usually buy. This area is present below the current price, where the buying interest or potential is the highest. A recognized demand zone typically has many buyers available with buying orders at that level.

The chart below will help you understand the demand zone concept more properly.

demand zone

demand zone

In the chart, you can price continually reversing to the upside after falling to the demand zone (shaded area).

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Main Types of Supply and Demand Zones

It's important to know the patterns involved in supply and demand zones. Like traditional price pattern analysis, supply and demand zones also have reversal and continuation patterns.

Reversal Patterns

These patterns simply refer to the situations when the prevailing price trend reverses from either up to down or down to up. To understand these patterns more clearly, we will take the example of two structures:

Drop-Base-Rally: In this structure, the price moves downward, remains around a general price level for some time to create a base structure, and finally rallies upward.

Rally-Base-Drop: In this structure, the price rallies upward, creates a base structure, and then moves significantly downward.

drop-base-rally and rally-base-drop

drop-base-rally and rally-base-drop

On the price chart below, you can identify the supply zone on the extreme left side, and the demand zones represented by the next two structures.

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How to identify the supply and demand zones

How to identify the supply and demand zones

In the supply zone, you can see the price rallying up, pausing for some time, and then dropping significantly, following the rally-base-drop structure. The thing to notice is the way price leaves the base structure. The long candles representing the drop show the intensity of the supply-demand imbalance at that price level.

In the demand zone structures, you can clearly see price dropping significantly, creating a base, and then rallying up, following the drop-base-rally structure.

Continuation Patterns

Continuation patterns refer to a situation where the price trend continues moving in the direction, either up or down, of the prevailing overall price trend. These patterns are generally weak as, most of the time, price tends to break through these structures. To understand continuation patterns more clearly, let's have a look at their two types:

Drop-Base-Drop: In this structure, the price drops, pauses for some time to create a base, and then continues to move down in a strong fashion.

Rally-Base-Rally: In this structure, the price rallies up, pauses for some time to create a base, and then resumes its move upward.

drop-base-drop and rally-base-rally

drop-base-drop and rally-base-rally

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On the chart below, the demand zone is present on the extreme left side, and the supply zones are represented by the next two structures.

How to identify the supply zone

How to identify the supply zone

In the demand zone, you can see the price rallying up, waiting for a while to create the base, and then continuing to move upward, following the rally-base-rally structure. The long candles show the continuation in the price rise.

In the supply zones, you can see the price dropping significantly, waiting for a while to create the base, and then continuing to move downward, following the drop-base-drop structure.

Reversal patterns usually have more chances of success than continuation patterns, as they tend to be stronger patterns, ones with greater momentum.

How do you trade for demand and supply in Forex?

How to Identify Supply and Demand Zones on a Chart?

Identifying market imbalances is the first step to finding supply and demand zones. In simple words, market imbalances usually precipitate big price shifts in one direction (either upward or downward) based on supply and demand.

The chart below shows us that:

  • When the demand for something is greater than the supply, the price rallies up, represented by big green candles.

  • When the existing supply is greater than demand, the price drops, represented by big red candles.

How to identify the supply and demand zones

How to identify the supply and demand zones

These big candles show price movements that reflect market imbalances on the chart. The key point to remember when trying to identify market imbalances is to focus on the larger candles, known as explosive price candles or "Extended Range Candles" (ERCs).

Now that you can easily find market imbalance on the chart, you can move forward to follow three essential steps to identify supply and demand zones.

Step 1: Spot the Current Price

First, you need to spot the current price on the chart. Then, look at the left side of the chart and find a big, strong lineup of candles either moving up or down. Typically, supply zones show strong preceding upward price moves, while demand zones show strong preceding downward price movements.

how to spot the current price

how to spot the current price

Step 2: Find ERCs

Now, look to find ERCs. You can identify these candles by their long bodies with little to no wicks. Remember that if any candle has an equal size of wicks and body, it is usually not considered an ERC. This is how ERCs look on a price chart:

how to find ERCs

how to find ERCs

Step 3: Identify Origin of the Price Movement

Finally, you need to identify the origin of the price movement on the chart. As shown in the chart below, the price rallied up with small-sized candles, paused for some time, and then dropped downward as shown by several ERCs. This is the origin we need to form the base of the supply zone. This base will help us draw the zone.

how to identify origin of the price movement

how to identify origin of the price movement

Are supply and demand zones the same as support and resistance

Best Supply and Demand Zones Indicators

There are many indicators that you can use to confirm supply and demand zones on a price chart. Some of the best ones include:

Pivot Points

Most traders use daily or weekly pivot points to indicate potential supply and demand zones - also referred to as resistance and support levels. These points are technical analysis indicators that provide traders with an average of high, low, and closing prices from the last trading day.

Support and Resistance Levels

The concepts of support and resistance help traders understand and evaluate chart patterns. Support refers to price levels where the downward movement stops due to increased demand for an asset.

On the other hand, resistance describes price levesl where upward price movement reverses with a sell-off.

Fibonacci Levels

Fibonacci levels help traders identify possible turning points at supply and demand zones. In the chart below, the Fibonacci 61.8% retracement level is reveals a significant supply/resistance level.

fibonacci levels

fibonacci levels

How to Draw Supply and Demand Zones

After identifying supply and demand zones on a chart, you can now draw the zones yourself.

Supply zones are either rally-base-drop or drop-base-drop. You can draw them with three methods, including:

The Conservative Method: In the base structure, the distal line (first line) needs to be placed at the top of the wick of the highest candlestick - identified here as the base candlestick - and the proximal line (second line) needs to be placed at the base candlestick body low.

the conservative method

the conservative method

The High-Risk Method: In the base structure, place the distal line at the highest wick and the proximal line at the lowest wick of the base candlestick.

the high-risk method

the high-risk method

The Low-Risk Method: In the base structure, place the distal line at the highest wick of the base candlestick, and the proximal line at the base candlestick body’s high.

the low-risk method

the low-risk method

On the other hand, demand zones are either drop-base-rally or rally-base-rally. Like the supply zone, you can draw the demand zone in three methods but in the opposite way.

The Conservative Method: In the base structure, the distal line needs to be placed at the lowest wick of the base candlestick, and the proximal line should be at the base candlestick body high.

the conservative method

the conservative method

The High-Risk Method: In the base structure, place the distal line at the lowest wick of the base candlestick, and the proximal line at the base candlestick’s highest wick.

the high-risk method

the high-risk method

The Low-Risk Method: In the base structure, place the distal line at the lowest wick of the base candlestick, and the proximal line at the base candlestick’s body low.

the low-risk method

the low-risk method

Best Supply and Demand Zones Trading Strategies

If you are looking for some supply and demand forex trading strategies, here is what we suggest you go for:

Range Trading Strategy

If there are well-defined supply and demand zones, you can opt for a range trading strategy. Most traders use stochastic indicators to identify overbought and oversold market conditions. Since range trading is a non-directional trading (trend-wise), you can easily identify long and short entries in the forex market.

Once you view all the conditions on a longer-term chart, you can then zoom into a smaller-term time frame to help spot the perfect price entry point.

range trading strategy

range trading strategy

Breakout Strategy

Since prices always keep fluctuating in the forex market, traders look for ways to enter into the market in favorable conditions, such as in the direction of a price breakout from a narrow trading range, as it could be the start of a new long-term trend.

Take the example of the USD/JPY chart, which is the forex ticker representing the US Dollar's worth against the Japanese Yen. The chart shows a breakout of the trading range, but unfortunately, price fairly quickly drops all the way back into the demand zone. This is known as a false breakout. Traders who bought long based on price breaking above the recognized supply zone initially enjoyed an open profit, but that profit then quickly turned toward a substantial loss.

breakout strategy

breakout strategy

Risk Management Strategy

Demand/support and supply/resistance zones work both provide information to the trader about where to possibly initiate a trade.

This allows various traders to implement different trading strategies. For example, range traders who sell at the supply zone can set stops above the supply zone to limit their risk, while aiming for profits if price turns to the downside, heading back toward the demand zone.

risk managment strategy

risk managment strategy

Laws/Rules of Supply and Demand

Supply and demand form the foundation of economics and are central concepts in trading as well. When we refer to the 'laws' or 'rules' of supply and demand in trading, we're talking about identifying certain characteristics or 'zones' on the chart where price has shown a strong reaction. These characteristics can be broadly classified into time, strength, and freshness.

Time

Time refers to the duration a price remains in a supply or demand zone. If the price stays in a zone for an extended period, it often indicates a strong supply or demand at that level. The longer the time spent in a zone before a significant price move, the stronger the zone is likely to be.

Strength

Strength is about how quickly and sharply the price moves away from a supply or demand zone. A strong move away from a zone indicates a significant supply and demand imbalance at that level. The stronger the move, the more imbalance there is between buyers and sellers, and hence, the more significant the zone may be for future trading opportunities.

Freshness

Freshness relates to how many times a price has revisited a supply or demand zone. Fresh zones, i.e., zones that have not been revisited since their formation, are often more effective for trading. Every revisit to a zone will consume some of the orders there, so a fresh zone is likely to have a higher density of unfilled orders, leading to a stronger reaction when the price returns.

Visualizing these concepts on a chart could help, so consider using a trading platform where you can draw supply and demand zones, note time spent strength of departure, and track revisits. Over time, you'll gain a feel for how these principles apply in real trading situations. Practice with a demo account until you are comfortable applying these laws in live trading.

5 Tips to Beginners for Successful Supply and Demand Trading

Supply and demand are fundamental principles in Forex trading, shaping all market trends and turning points. They represent a market's willingness to buy or sell a certain product at different price levels. As a beginner trader, mastering the art of reading supply and demand can be a game-changer. Here are five tips to help you successfully navigate supply and demand in trading:

  • 1

    Combine with Technical Analysis: Understanding supply and demand alone is not sufficient. These principles must be combined with technical analysis, which includes studying chart patterns, price movements, and indicators. Understanding these can give you insights into how the market may react to certain supply and demand conditions

  • 2

    Risk Management: Always employ sound risk management strategies. Only risk a small percentage of your trading capital on each trade, typically no more than 1-2%. This will allow you to withstand multiple losses without draining your account and give you the chance to improve your strategy over time

  • 3

    Identify Strong Imbalances: Look for significant imbalances between supply and demand, which could indicate a potential trade. This can be done by identifying zones where prices have rapidly risen or fallen

  • 4

    Use Longer Time Frames: As a beginner, start with longer time frames like daily or weekly charts. They provide a clearer market overview and are less influenced by market noise than shorter time frames

  • 5

    Use Indicators for Confirmation: While the supply and demand theory can be powerful, using additional indicators for confirmation can provide extra assurance. Indicators like volume indicators, relative strength index (RSI), or moving averages can help confirm your supply and demand analysis

Pros and Cons of Supply & Demand Trading

While this approach has many benefits, it also comes with its own set of challenges. Here's a look at some of the pros and cons:

👍 Pros

Simplicity:
Supply and demand trading is intuitive and relatively straightforward. It's based on the fundamental economic principle of price determination - where supply meets demand

Applicable to All Markets:
The concept of supply and demand applies to any market that involves buying and selling, making it a universally applicable trading strategy

Predictive Nature:
Supply and demand zones can often indicate future price movements, allowing traders to anticipate potential trades

Clear Risk and Reward:
These zones also offer clearly defined points for entry, stop losses, and profit targets, which aids in solid risk and reward management

👎 Cons

Subjectivity:
Identifying supply and demand zones can be somewhat subjective and may vary among traders. This lack of a standard definition can lead to discrepancies in its application

Ignoring Market Noise:
Smaller price movements or 'noise' within the supply and demand zones might result in false signals, which can cause the trader to enter or exit trades prematurely

Lagging Indicator:
Supply and demand zones are typically based on historical data, which means they might not always accurately predict future price movements

Requires Patience:
This method often requires waiting for the price to reach the defined supply or demand zones, which can test a trader's patience, particularly in a less volatile market

Expert Opinion

The logic of supply and demand zones is clear as they form within ranges where one side or the other becomes “exhausted” and is unable to push the trend further. Identifying them on an actual chart is more challenging. The issue is that extremes occur at different heights. By expanding or narrowing the visual supply or demand zone, a trader might mistake the desired for the reality. Therefore, the advice here is simple, practice building key support and resistance levels on historical price data, which will serve as the boundaries of these zones. Learn to quickly identify these zones visually, verifying your decisions in a demo account's tester using historical quotes.

Oleg Tkachenko

Oleg Tkachenko

Author and expert at Traders Union

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