Trading insights
Supply and demand zones are a crucial part of technical analysis and provide valuable insights into market trends and price movements. By understanding how supply and demand relate to each other, traders can better identify potential trading strategies and make informed decisions.
In this blog, SDC Trader explains everything about supply and demand zones in trading: what they are, how to recognize them, and how to apply them in your trading strategy. Whether you are just starting out or are an experienced professional, understanding these zones can be an essential tool for creating good setups and growing your wealth.
What are supply and demand zones?
Supply and demand are actually quite simple: the relationship between supply and demand determines the price, or what people are willing to pay. If there is more supply than demand, the price must decrease or the supply and must be reduced. Conversely, if there is shortage, the seller can essentially ask for whatever they want, as buyers will still be lined up. Examples of this include shortage of supply due to Covid, which led to significant price increases (inflation), or the demand for high-quality chips from Nvidia due to the AI hype.
In my price action trading strategy, I focus on predicting where the price will reverse or continue moving in the same direction. I look for levels where buyers and sellers congregate and where supply and demand meet. Supply and demand zones are specific areas on a chart where the price of an asset often stagnates, indicating where supply and demand converge. These zones represent locations with a significant concentration of buying or selling pressure, which can influence the direction of price movements.
In a supply zone, there is an excess of sellers, leading to a price decline. This occurs when supply exceeds demand and traders are willing to sell at lower prices. Conversely, in a demand zone, there is an excess of buyers, resulting in a price increase. This happens when demand exceeds supply and traders are willing to buy at higher prices.
Why are supply and demand zones important?
The market tends to eventually return to the zone where an imbalance has occurred in order to rectify that imbalance. These zones serve as magnets for price movements, which traders can capitalize on. Additionally, supply and demand zones act as powerful support and resistance levels, as previous highs or lows have been broken from these areas, initiating new trends. Therefore, when the price returns to these zones, it is likely to reverse and breathe new life into the recently started trend. This allows for effective risk management, as you have clear levels at which your analysis is invalidated. With limited risk, you can achieve good returns!
How to identify supply and demand on a chart?
Simply put, if there are as many buyers as sellers in the market, the price does not move, indicating complete agreement on what the fairest price is. However, when the price suddenly moves significantly, it indicates that either buyers or sellers have gained the upper hand. This price imbalance is essential for understanding supply and demand. When demand exceeds supply, the price rises, which is shown by large green candles. Conversely, when supply surpasses demand, the price falls, as indicated by large red candles.The key is to look for the origin of a movement that has taken out a previous high or low—essentially, the zone where the imbalance occurred.
What are the key types of supply and demand?
Understanding the different patterns of supply and demand zones is crucial. Similar to traditional price pattern analysis, these zones have both reversal and continuation patterns.
Reversal patterns
Reversal patterns refer to situations where the current price trend reverses, either from up to down or vice versa. Two important structures are:
Drop-base-rally: In this structure, the price drops, stays at a certain level to form a base, and then rises again.
Rally-base-drop: Here, the price rises, creates a base structure, and then drops significantly.
In the scheme below, you can see the both reverals patterns on the left side. After an initial movement, the price pauses for a while, after which a movement in the opposite direction begins. The base in a drop-base rally pattern is called demandzone, the base in a rally-base-drop pattern a supplyzone.
Continuation patterns
Continuation patterns indicate situations where the price trend continues in the direction of the current trend, either up or down. These patterns are generally weaker, as the price often breaks through these structures. Two common types are:
Drop-base-drop: In this structure, the price drops, pauses to form a base, and then moves downward again.
Rally-base-rally: Here, the price rises, pauses briefly to create a base, and then resumes its upward movement.
In the sheme below, you can see the continuation patterns on the right site. After an initial movement, the price pauses for a moment, after which the next movement is in the direction of the first, essentially a continuation. The basing zone in a drop-base-drop pattern is the supplyzone, the demandzone is the basing part of the rally-base-rally pattern.
Overall, reversal patterns tend to have a higher probability of success than continuation patterns because they generally have stronger structures and more momentum. However, continuation patterns should not be underestimated, because the trend is valid until proven otherwise. In other words: the trend is your friend...
What steps should you take to identify supply and demand zones?
Recognizing supply and demand zones on a chart requires practice and experience. Here are some guidelines to help you get started:
Start with the current price: Look to the left on the chart to examine historical data.
Look for levels where previous highs or lows were broken: If a previous high has been broken, the zone where that movement began is a demand zone. If a low has been broken, a supply zone has formed from the area where the decline started.
Search for balance zones: Supply and demand zones arise from areas where there was balance between supply and demand, and the price moved sideways. Look for balance zones from which an impulsive movement began, ultimately breaking a previous high or low.
Identify price levels with multiple reversals: These zones can often be recognized by several reversals at the same price level. Look for areas on the chart where the price has reversed repeatedly, indicating potential support or resistance levels.
Pay attention to areas of high volume: Supply and demand zones may be found in areas with high trading volume, indicating strong buying or selling pressure. Look for peaks in trading volume on the chart that may signal potential demand or supply zones.
Use technical indicators for confirmation: Technical indicators like the Relative Strength Index (RSI), Fibonacci levels, or double Stochastics (cycles, I use Bressert) can provide useful signals for potential reversals at supply or demand zones.
Drawing supply and demand zones
After identifying supply and demand zones on a chart, it's time to draw them. As explained supply zones can be classified as either rally-base-drop or drop-base-drop. There are three methods to draw these zones, but I use only two to avoid the highest risk method:
Conservative method
Use the bottom of the body of the last green candle (before a drop to a new low) as the bottom of the supply zone and extend it to the high of that or the subsequent candle.
Higher-risk method
Use the bottom of the entire last green candle, including the wick (before a drop to a new low), as the bottom of the supply zone and extend it to the high of that or the subsequent candle.
Demand zones are either drop-base-rally or rally-base-rally. You can also draw these zones in three ways, but in the opposite manner:
Conservative method: Use the top of the body of the last red candle (before a rise to a new high) as the bottom of the demand zone and extend it to the low of that or the subsequent candle.
Higher-risk method: Use the top of the entire last red candle, including the wick (before a rise to a new high), as the bottom of the demand zone and extend it to the low of that or the subsequent candle.
Pros and cons of both methods
The advantage of the conservative method is that the drawn zone is slightly smaller than with the higher-risk method, resulting in a sharper entry and therefore better risk-reward ratios. You might use the higher-risk method if you prefer to be in the trade or if you want to build your position gradually.
However, the downside is that there is a possibility that the price may not reach this zone and could reverse before your entry level. In that case, the anticipated movement may occur, but without you. However, missing a good trade is far better than entering a bad one….
In the 2 graphs below you see two identical recent weekly charts of AMD. On the left hand the higher-risk method and on the right side the conservative method. Although a better risk-reward with the conservative method, the setup wasn't triggered, so you missed the $30 reversal. In case you choose the method with a lower risk-reward, the setup was triggered and you would've been paid.
Tips for drawing supply and demand zones
Once you've identified potential supply and demand zones on a chart, it's important to mark them for future reference. Here are some effective steps to do this:
Use rectangles: The simplest way to mark supply and demand zones is by drawing a rectangle. Determine the bottom and the top of the zone, and draw a rectangle across the chart at that level. Ensure the rectangle extends through the chart so it's clear where the zone begins and ends. More on how to define a zone later.
Choose a distinct color: To differentiate the zone from other lines and indicators on the chart, you can fill the rectangle with color. This makes the zone more visible and facilitates chart analysis.
Label the zone: To help you remember what the zone represents, you can give it a short description. For example, you could label a demand zone as “DZ” and a supply and demand zone as “SZ”.
Evaluate and adjust as needed: After marking the zone, it's important to assess it in the context of price action. Adjust the zone as necessary to accurately reflect areas of support or resistance.
Marking supply and demand zones on a chart is a straightforward step that helps traders identify key areas of support and resistance.
Setups using supply and demand zones
Supply and demand zones can be applied in various ways in trading. Here are some popular approaches:
Trading reversals: a common strategy is to look for supply and demand zones where the price has previously reversed. These zones can serve as indicators for potential reversal points in the future. For example, when the price reaches a previous demand zone, traders might look for signals of a reversal, such as a bullish candlestick pattern or an oversold condition on a technical indicator.
Trading breakouts: another strategy focuses on supply and demand zones where the price has stalled in the past. These zones can help identify potential breakout points in the future. For instance, when the price approaches a previous supply or demand zone, traders might look for signs of a breakout, such as a bullish candlestick pattern or a significant spike in trading volume.
Trading with the trend: some traders utilize supply and demand zones to identify support or resistance within a broader trend. For example, when the price is in an uptrend, they may look for demand zones where the price has previously reversed, using these zones as potential buying opportunities.
Setting stop-loss and take-profit levels: supply and demand zones can also be used for setting stop-loss and take-profit levels. For example, traders might place a stop-loss just below a demand zone to limit losses if the price falls below that level. They might also set a take-profit level just below a supply and demand zone to lock in profits when the price reaches that level.
With enough practice and experience, traders can become proficient in applying supply and demand zones to support their trading decisions.
Advantages and disadvantages of supply and demand zones
Like any trading strategy, there are both benefits and drawbacks to using supply and demand zones. Here are some key points to consider:
Advantages:
Easy to identify: supply and demand zones are straightforward to recognize on charts, as they are areas with significant buying or selling pressure.
Clear entry and exit points: these zones provide clear entry and exit points for trades, as they represent important support and resistance levels.
Optimal risk-reward: by offering clear entry and exit points, you can achieve substantial profits with tight stop-losses, while keeping risk limited.
Applicable in any market and timeframe: supply and demand zones work across all asset categories, including stocks, indices, crypto, and commodities.
Combining with other indicators: they can be used alongside other technical indicators, such as moving averages, Fibonacci levels, RSI, or cycles, for additional confirmation of a setup.
Disadvantages:
Subjectivity: identifying supply and demand zones can be subjective, as traders may have different interpretations of what constitutes a significant support or resistance level.
Not always reliable: while these zones can be useful for identifying potential support and resistance levels, they are not always reliable in practice. The market is unpredictable, and traders must be prepared for the risk of a zone being breached.
Time-consuming: identifying and marking supply and demand zones on a chart can be time-consuming and often requires considerable practice and experience to do effectively.
Applying supply and demand zones in your trading strategy can be a valuable way to identify potential setups and key areas of support and resistance. However, traders should be aware of the risks involved. Past returns do not guarantee future results. Investments can decrease in value.
Conclusion
Supply and demand zones are an essential aspect of technical analysis and are crucial for understanding market trends and price movements. These zones mark areas where significant buying or selling pressure has emerged, leading to reversals. By identifying these zones, traders can determine potential entry and exit points, helping them make informed decisions.
Recognizing supply and demand zones requires practice and an understanding price action. Trading strategies can focus on reversals, breakouts, and trend confirmations, with these zones serving as reference points for placing trades and managing risks.
While there are clear benefits, such as providing clear entry and exit points, traders should also be mindful of the subjectivity and unreliability that come with identifying these zones. It's important to combine supply and demand zones with other technical indicators for extra confirmation and to be prepared for the unpredictability of the market.
Overall, supply and demand zones can be a powerful tool for both novice and experienced traders, provided they are applied with the right caution and strategy.
If you're not confident in your ability to draw the right zones, or if you don't have the time or desire to conduct your own research, you can certainly take advantage of the benefits that a subscription with SDC Trader offers; the homework is already done, the zones are marked, and you only need to place the limit orders with your broker. Click on these two buttons for more information about subscriptions or to sign up directly.
