How to use supply and demand zones in trading
Most textbooks for novice traders focus on patterns and resistance/support levels. Many patterns have an unambiguous interpretation, so levels and trend lines are easy to build according to the visible extremes. But the financial market is flexible and unpredictable. Instead of a single reversal pattern, a double or even triple top can be formed. The resistance level can be easily broken with the continuation of the trend, or per contra, the result may turn out to be false. The price may not reach the key levels or unfold beyond its bounds.
Levels are lines formed by the extremes of the line, and the range of price movement near these levels is the supply and demand zone.
From this review you will learn:
What supply and demand zones are in trading. How to determine their boundaries on the graph.
What tools are used to find price imbalance ranges.
How zone models can be used in trading.
The review will help you to understand in general terms the reasons for the formation of supply and demand zones, as well as to gain insight into the differences from the classical key levels and learn how to apply them in strategies.
What are supply and demand zones?
Supply and demand zones are part of the Price Action system. They result from a method of technical analysis used in day trading and are the periods of sideways price movement that happen just before explosive price movement. They also represent the range in which the maximum demand or supply is formed, while a strong imbalance develops towards the buyers or sellers. In these zones, the price reversals after strong movements, as well as the beginning of a new trend are most often observed.
This is the essence and reasons for the formation of ranges:
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You sell apples for 50 USD per 1 kg. Other sellers follow you and also set a similar price. Buyers behave actively and buy up all the apples, so the sellers have nothing left.
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The next day, some sellers decide to raise the price to 55 USD. The other sellers do not want to lose additional income and also set a price of 55 USD. Now apples are bought not so actively and therefore it takes more time to sell the same volume. But eventually, all the apples are still sold out.
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The next day, some sellers decide to raise the price even higher – up to 60 USD. Buyers do not like this price, and some of them refuse to buy. Some part of the apples is not sold out, but the sellers are happy with it because the margin paid off the part that they could not sell.
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The next day, the most greedy seller sets the price at 65 USD. Others follow him hoping that the popular goods "will be bought anyway." But buyers declare a boycott. Then, sellers reduce the price to 60 USD. But buyers understand that they will achieve their goals and continue the boycott. The price falls rapidly. As a result, the price returns to 50 USD, so buyers are satisfied and ready to buy again.
The supply zone
In this example, the level of 50 USD is a strong level acting as a resistance to the trend originating from the price of 10 USD. The price breaks through this level and resistance turns into support. After rising to 65 USD, the price returns to 50 USD and again starts up from that. It is possible that later other fruits will appear on the market and apples will fall in price again to 10 USD. But before that, the price chart will show another rise to 65 USD.
The zone between 50 USD and 65 USD is the supply zone.
Rules for the formation of supply and demand zones
The demand zone
The demand zone is a zone in which there is an imbalance towards buyers. It is formed at the very bottom of a downtrend. In contrast, the supply zone is formed at the top of the chart on an uptrend.
There are no uniform rules for the designation of supply/demand zones. In most sources, they indicate the range in which the trend unfolds for a while; the zones are located at the end of an uptrend or downtrend. But there are also examples of the formation of intermediate zones, which can then break up or down.
Stages of building supply and demand zones:
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Determination of highs and lows by similarity with the rules for building key levels.
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Determination of the boundary of the probable zone by the farthest extremes and near extremes. Near extremes are earlier, and far extremes come later.
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Simultaneous searches for supply and demand zones on the same chart.
Formation of a demand zone
In the example given, the demand zone is formed by the first three candles that drew a strong support level. That is the line of near extremes (the first horizontal line from top to bottom). The line of the distant extremes is drawn through one point called the shadow. The resulting zone is the demand zone.
The price has unrolled several times in the demand zone and is currently going up. To build a supply zone, zoom out and look for the boundaries of a possible supply zone.
Formation of the supply zone
The far extreme of the supply zone (the uppermost line) is based on the level of the previous short-term consolidation and shadow. The lower level is based on the extremes of the current flat movement. The supply zone itself is indicated by the number "2". It is quite possible that the price, after entering the supply zone, will break through its upper (far) level and continue its upward movement. Then you will need to zoom out and look for a new probable zone.
Note that in the screenshot, the range between the supply and demand zones forms a flat area, within which the price moved, periodically breaking this area into zone "1" or zone "2". But since these are zones of excessive supply and demand, the trading volumes returned the price to the flat area.
The reason for the formation of zones is the setting of pending orders. Example for the demand zone:
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The sellers' take profits are set in the demand zone. Take profits are pending orders to buy an asset (close short positions). Accordingly, mass purchases turn the price up. Each trader has his own take profit setting principle: someone puts it at the support level, another person places it a little higher, while yet another trader waits for a pattern to form. The heterogeneity of the levels forms a zone in which local extremes are formed as shown in the graph above.
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Buyers' stops are set in the demand zone. Buyers are counting on the growth of the trend, but sellers are pushing the price down with a high volume of transactions. At the support level, stops are engaged, which are the buyers' orders to sell the asset. After that, the price goes even lower. At some point, most buyers agree to the current price and through volume purchases, they force the price to rise. Buyers' stops also form a zone of accumulation of the largest volumes that can turn the price up from the near boundary of the zone or push the price further down to the far boundary of the zone.
Another reason for the formation of zones is the placement of large limit orders. For the supply zone, these are sell orders. Large market makers cannot present a large volume for sale without affecting the price reduction. Therefore, they are looking for zones of mass accumulation of orders for the purchase of small traders.
As soon as the price reaches the beginning of the demand zone (which creates an imbalance towards buyers), a large bid is placed, which "absorbs" the small volume and pushes the price further down to the second boundary of the zone. When there is a predominance of buyers again, the price returns to the upper limit of the demand zone, where large sellers can re-enter the market.
Thus, there is a movement within the zone with a regular exit of the price beyond its bounds. At a certain point, the supply (sale orders) ends and the price leaves the zone, breaking through the near level, and travels upward.
Indicators that trigger the supply and demand zones
Fibonacci levels. The price during the correction often stays between intermediate Fibonacci levels, where they act as zones.
Determination of zones using Fibonacci levels
In this example, Fibonacci levels on a downtrend show a demand zone. The price retested the near level, then could not return to the far level again, and after it went up breaking the near level. The following Fibonacci levels could also be used to draw local zones.
Pivot levels. Pivot levels are a tool for determining possible reversal levels. The classic points show three levels of resistance and three levels of support, the significance of which increases as you move away from the current price. The demand zone can be built between the 2nd (S2) and 3rd (S3) supports, and the supply zone is between the 2nd (R2) and 3rd (R3) resistances.
Building of the suggested supply zone using pivot levels
Early pivot levels can also indicate the intended zones, but it is better to focus on the current ones. The last R2 level shows the near (lower) boundary of the possible supply zone. It makes no sense to set the far boundary on R3, it is more reasonable to set it according to the last short-term consolidation zone of the downtrend. Note: the build zone occupied two good reversals on the left side of the chart. This confirms that the zone is strong enough and a new temporary consolidation or downward reversal is possible here.
Oscillators. Oscillators confirm a possible reversal. Zones can be built based on the coinciding price and oscillator reversals within the overbought/oversold ranges. Alternatively, you can receive a confirmation signal from the oscillator when the price is already within its zones.
Trend indicators can also be used to determine supply and demand zones, but they better demonstrate the moment of leaving these zones.
How to use zone models in trading:
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Search for transaction opening points. Zones can be regarded as a section of a temporary flat, the exit from which occurs in one of the directions. The signal must be confirmed by other instruments.
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Setting the take profit and stops. If you assume that there is a battle between sellers and buyers within the zones, then it would be reasonable to put stops outside the zone and close the transaction before the price enters the zone.
Do not forget to take into account the fundamental factor. For example, in the demand zone, theoretically, there is an increased demand on the side of buyers, which should turn the price up. But the news release may change their opinion and the downtrend will only increase the speed.
Top 7 tips for beginners on trading in supply and demand zones:
Look for zones on timeframes from H1 and above. Zoom out the chart to better see which levels and in which zones reversals have occurred the most.
Pay attention to the following points: the horizontal boundary of the distant extremes is built taking into account the shadows. The far extreme is a stronger and more significant level than the near one. If the price has passed the level of the near extremes, a reversal at the one farthest is most likely.
Most often, the price makes a level test and two retests in the zone, followed by a breakout; for example, a flat formed on a downtrend with a clear demand zone. After a maximum of three touches of the bottom line, the final upward exit from the zone will occur.
Watch for the formation of reversal patterns when the price first enters the zones and when it is firmly inside the zones. They will suggest to you the moment of the reversal.
Set your stops at several points outside the zones: above the supply zone and below the demand zone.
Pay attention to round levels, because supply and demand zones are also often formed near them.
Also, keep an eye on the volumes. If a significant increase in volumes is observed when moving from the far border of the zone to the near one, this indicates that an increasing number of investors are entering the market, moving the price towards a reversal.
The technique of zone trading only at first glance seems complicated, but everything becomes clear after several attempts to determine the boundaries of the zones. Boundaries are a kind of first and second levels: if the price breaks through the first level, it means that it will most likely reverse at the second. Therefore, several horizontal levels are built on the chart, and the space between them determines the supply/demand zones.
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Summary
Things to know about the supply and demand zones in Forex:
These are zones where there is a significant imbalance towards buyers or sellers. The support is formed in the demand zone, and resistance is formed in the supply zone.
In these zones, a reversal is most often observed after the retest of the extreme boundary and the beginning of a new trend.
There are no uniform rules for building zone boundaries. It is best to build them visually, zooming out the image.
Trading strategies by zones: search for reversal points and moments when the price leaves the zone and moves towards a new direction.
Tools for building strategies are trend indicators, reversal-confirming oscillators, patterns, Fibonacci levels, and volume indicators.
Try to find several zones on the demo account. The skill to detect them comes with practice.
FAQs
How do supply and demand zones differ from resistance and support levels?
The key levels are lines at which the trending tipping point occurs. However, the price may still have impulsive movements, such as the resistance of one of the parties, and the actions of market makers. The price may give a false breakout of the level, or vice versa, it may not quite reach it. A zone is a range to which the price has repeatedly approached in the past and where a price reversal has repeatedly occurred. It is difficult to draw lines through 4 or more extremes, because they are at different levels. This action requires zones.
Where to apply zone trading strategies?
Zones are the range of the most likely trend reversal. Therefore, most of the strategies are based on finding a signal at the moment of leaving the zone. However, breakouts in the direction of the initial trend are also possible. Another option is swing trading, which is trading on local movements at the time of zone retests.
How to find supply and demand zones?
Visually or by using the indicators. Horizontal resistance and support levels can act as the centerline of the zones. The possible reversal in the zones may also be determined using patterns and oscillators.
What timeframes do zone trading work on?
It is better to build zones at intervals starting from H1. In scalping, a fast price movement does not give you enough time to get the confirmation signals.
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Team that worked on the article
Mikhail Vnuchkov joined Traders Union as an author in 2020. He began his professional career as a journalist-observer at a small online financial publication, where he covered global economic events and discussed their impact on the segment of financial investment, including investor income. With five years of experience in finance, Mikhail joined Traders Union team, where he is in charge of forming the pool of latest news for traders, who trade stocks, cryptocurrencies, Forex instruments and fixed income.
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Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.
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