Contents: Supply & Demand
- What are supply and demand zones?
- Wykoff and market structure
- Types of supply and demand patterns
- How do you identify supply and demand zones?
- Drawing supply and demand zones
- How can you confidently identify a supply or demand zone?
- Supply and demand zone indicators
- Supply and demand vs. support and resistance
- Supply and demand zone trading strategy
What are supply and demand zones?
Even before it becomes evident on a chart, the forces that move markets assemble and strengthen in the background. Traders who follow a price action strategy try to identify these conditions in advance. During periods of sideways price action, supply and demand zones can be drawn. When a security’s value enters one of these, explosive price moves may be imminent.
The distinction is pretty straightforward: a supply zone forms before a downtrend, while demand zones can signal an uptrend.
Supply and demand trading strategies use the price returning to these zones as entry and exit criteria.
What are zones in trading?
The origin of a strong downtrend is called the supply zone or distribution zone. The area in which a strong uptrend develops is called the demand zone or accumulation zone. In each case, price action indicates an increasing number of buyers and sellers, respectively, even though they may not yet actually have gotten around to buying and selling on a large scale.
If you like, you can skip ahead to see how to supply and demand zones are determined. However, we recommend a quick summary of the background to give you an idea of why this trading strategy works.
Wykoff & market Structure
Let’s think about the three simplest concepts in trading financial markets:
- When demand is greater than supply, the price goes up.
- When demand is equal to supply, the price goes sideways.
- When supply is greater than demand, the price goes down.
Financial markets move in phases described by the above conditions. This is why there are uptrends, downtrends, and price ranges – it all comes down to supply and demand.
The famous Richard Wykoff was one of the first market analysts to explain the interaction of these phases. He divided a typical price cycle into four periods:
- Accumulation
- Markup
- Distribution
- Markdown
Their meaning can be seen in Wykoff’s classic schematic of market action:
Gaining a deeper understanding of Wyckoff’s interpretation of typical market price action patterns will benefit any trader. For now, though, let’s focus on the fact that supply and demand zones are also known as accumulation and distribution zones.
The Role of Institutional “Whales
Wykoff explained how these phases come about largely in terms of the influence of the “whales”, which these days are large institutions like money centre banks in forex markets or hedge funds in the stock market. When buying, these big players can’t just put their whole order into the market at once, because the volumes are so large that doing so would move the price, raising the price they’ll have to pay. So, they buy incrementally within a specified price range instead.
Of course, in the modern world, even a large trade by a major institution comprises only a small portion of the total market. However, a very similar phenomenon occurs when multiple investors, sharing the same objectives and having access to the same information, make their moves at roughly the same time. This gradual expansion of orders causes what we see on the chart as a “demand zone”.
Equally, when these whales are selling a position, it can’t be all done in one fell swoop because the sudden oversupply pressure would send the price sharply lower and reduce their profits. They would soon end up selling into a market decline that was, in fact, caused by their own activity.
Even when these large orders are staggered, the market will eventually break out of the region in which it was trading. When these whales have been buying or selling considerable amounts, a period during which supply and demand are out of balance (i.e. a price trend) is bound to develop.
Types of supply and demand patterns
When trying to move from theoretical knowledge to practical application, it’s important to understand that the schematic above presents an idealised model. In real-world markets, there can be several periods of accumulation during an uptrend; similarly, downtrends can contain multiple distribution periods. This means that, just like in classic technical analysis of price patterns, we find supply and demand reversal patterns as well as supply and demand continuation patterns.
Supply and demand reversal patterns
We can see a simple example of reversal patterns below. The drop-base-rally is a bullish reversal pattern: once it has been confirmed that the price has escaped the demand zone, it will most likely continue to rise.
Inverting it, we find the bearish reversal pattern known as the rally-base-drop. An excess of supply has arisen, and the market responds by sending the price lower.
Supply and demand continuation patterns
Since price charts tend to be all squigly instead of showing smooth trajectories, how can we use supply and demand zones to determine whether a trend is only paused and will resume soon? The rally-base-rally is an example of a bullish continuation pattern, whereas the drop-base-rally indicates that a downtrend is likely to restart.
Spotting and interpreting these kinds of patterns is not always simple. However, when supply and demand zones can be identified with confidence, they can yield a great deal of understanding about which phase the market is in, what the underlying trend might be, and how long it has been in place.
As a general rule of thumb, you will want to look for reversals during a well-established trend. If a trend is new or still developing, continuations are what you want to watch out for.
How do you identify supply and demand zones?
Putting this theory into practice relies on finding the spot on the chart where demand overcame supply (for long trades) or where supply overcame demand (for short trades). Conceptually, the process for correctly identifying supply and demand zones is quite simple:
1. Read the current market price.
From there, trace the price action backwards on the chart.
Keep an eye out for large green or red candles.
Once found, locate the origin of those candles.
Finally, mark the zone around this origin.
Drawing supply and demand zones
Let’s elaborate on Step 5, which concerns determining the location and width of supply and demand zones. You’ll recall that in Step 3, we scanned the chart for large or significant candles, without going into detail as to the characteristics of these. There are two types of candle zones to look for on the chart, and either one will often precede a big price move:
- From a base
- From a single candle
Supply/demand base
In trading terms, a base is typically another way of referring to a temporary bottom in the market. But in the context of price action strategy, seen through the lens of supply and demand, a base means a small series of candles (typically less than 10) in a tight consolidation. If you like, you can think of this pattern as indicating that the market is making up its mind on whether to go higher or lower, with the forces that will actually determine future price moves gathering strength even though they have not yet made their presence known.
Single candle
This is simply when one candle provides enough information to draw the zone. This often occurs when two successive candlesticks form a hammer or shooting star. or other bullish or bearish engulfing candlestick patterns.
How can you confidently identify a supply or demand zone?
As with any form of technical analysis or trading strategy, there are strong signals and weak signals. It’s not always obvious, except in hindsight, which is which. Clearly, though, getting the best trading results relies largely on ignoring weak signals and taking action when we see strong ones.
The most credible trade setups based on supply and demand zones share all of the following characteristics:
Narrow price range
If the trading range that defines the zone is too wide or has too many long-wick candles, it becomes harder to draw the conclusion that price action represents accumulation from a whale.
Less than 10 candles
While a single candle can be enough to define a demand or supply zone, anything more than ten candles probably represents something other than accumulation or distribution. These kinds of cumulative trades can take a while to evolve, but waiting too long to place a trade can mean that the zone will get exhausted before a later re-test, when the price returns to previous levels.
Strong price move
When identifying a breakout, an “Extended Range Candle” or ERC is one of the most certain signals. This simply means a long, high-momentum candle with very short wicks, which shows a strong, significant price move that is likely to continue.
Fresh / untested
The most reliable zones are those which the price has not revisited since the breakout. The utility of supply and demand zones is time-bound; these opportunities don’t exist forever. Just like support and resistance levels, the more times supply zones and demand zones are tested, the more likely they are to fail.
Fakeout or “spring”
This pattern occurs when the price temporarily breaks out in the opposite direction, but then quickly reverses. This is a sign of big players conducting “stop hunting” to find extra liquidity for their accumulation or distribution.
Supply and demand zone indicators
It’s possible to buy supply and demand indicators, in the form of software, that have been custom-built for the trading platform. However, drawing supply and demand zones tends to be more of an art than a science.
Some of the best-known modern supply/demand traders and mentors like Sam Seiden still prefer to draw their zones pretty much by eye, using the rectangle tool available in most online price charts.
Supply and demand vs support and resistance
Supply and demand zones have a particular relationship with support and resistance levels (S&R levels); they are most often close together. However, these concepts are not quite the same.
Support levels are often defined by the low of a candlestick that has had at least two candlesticks with higher lows on either side. This is a good indication that the market is not willing to go lower at the present time. Resistance levels, similarly, are often drawn at the high of a candlestick that has at least two candlesticks with lower highs on either side.
Supply and demand zone trading strategy
Incorporating supply and demand zones as part of your trading strategy can often simplify and streamline the process of technical analysis, helping you to identify more potentially lucrative trades. Few traders rely on this technique exclusively, though. It is best to also use other trading methodologies, perhaps to confirm conclusions reached through S/D, as well as a sound risk management system.
Example: The S/D with 20 daily moving average Strategy
We can use the change in trend indicated by the moving average to add extra significance to the demand or supply zone, while also making the direction of the trade clearer. The procedure is as follows:
- Wait for the price to cross the 20-day moving average.
- Watch for a long-range candlestick in the direction of the MA cross.
- Mark the supply/demand zone as shown by the big price move.
- Set your entry order at the beginning of the price zone.
- Set your stop loss past the end of the price zone.
- Set your take profit order with a 3X risk: reward and/or at a support and resistance level.
In conclusion
Though transforming price action data into supply and demand zones is not foolproof, and a little more subjective than some technical analysts would prefer, it does have a number of things going for it. The method’s simplicity is certainly a virtue. Moreover, thinking in terms of the supply and demand of a security allows you to get a sense of what other traders may be planning and doing, giving you a kind of market insight that goes beyond the bare-bones numbers.
