Supply & Demand Zones
What are they and why are they so helpful in trading?
“Supply and demand” is a basic concept in microeconomics, an model to determine the equilibrium price in a certain market. No surprise we cross these terms in trading and financial markets frequently. What else is a market than a place where supply and demand come together. Financial markets are a special form of market. We constantly search for a way to determine the “correct” price for an asset only to get for a lower price and sell it for its fair value or even above.
Supply and Demand in Balance (Equilibrium)
Economic models always talk about the equilibrium and markets that are in balance, if so supply and demand are even and found their fair value of exchange for a good.
Reality is often a little different, supply and demand are very volatile and transitory. New information or data being released to public, expectations, feelings like fear and greed are influencing markets all around the world. This leads to overpricing and under-pricing of a good, every once in a while the price comes back to its fair value. Usually it is not lasting there for long.
Famous stock market expert André Kostolany once described it as following:
“The relationship between the stock market and the economy is like a man walking his dog. The dog follows his master, and yet is always ahead of him—just like the stock market is always ahead of the economy, because it’s role is to anticipate the future.
During the walk, the dog (i.e., stock market) stops and looks back to make sure the wanderer (i.e., economy) is still “following” and the dog then continues on walking. But, if the wanderer stops, the dog runs back towards the wanderer. In a similar way, stock markets often correct fast to equilibrium, when economic data grow at a slower pace than expected. One should never ignore the underlying fundamental drivers of the markets in which he trades.”
Ok, you might ask yourself now, cool story bro, but how does this help me in my daily endeavor to become a profitable trader?
Simple as that, there are ways to identify zones where supply or demand are gathering, where they accumulate or distribute. These areas, once identified, can be used for trading. In the following sections we will find out what these zones actually are, how we can identify and draw them on our charts and finally how can we use them for trading the markets.
What are Zones of Supply and Demand?
As described above, supply and demand are fundamental components of all markets. For each transaction we need at least one person who is willing to sell (supply) a good and another one who is willing to buy (demand) it for a given price.
By talking about trading we can identify zones where this is happening at a much larger scale than in other areas on a chart. But let’s start with the basics of supply and demand here.
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 up down
Financial markets tend to move in phases of the above. There are up- and down-trends or price ranges (sideways).
Richard Wyckoff was one of the first market analysts to explain the interaction of these phases, giving them four labels:
Four phases of a market cycle according to the ideas of Richard Wyckoff
Accumulation phase
Markup phase
Distribution phase
Markdown phase
So each every cycle of a market always consists of the four phases, accumulation, markup, distribution and finally the markdown. Accumulation and distribution are the two phases we are looking at specifically in this article as they are the origin of the next up- or down-trend. Wyckoff actually created a whole trading system based on this.
A supply zone is the origin of a strong downtrend, where many market participants distribute (sold) their assets among willing buyers. Often the case for smart money dumping on dumb money.
Vice versa a demand zone is the origin of a strong uptrend, where the smart money accumulates as much as possible of an asset before the price starts to significantly. Often by buying from weak hands that are to afraid to stay in the market.
Big players can’t just put their whole order into the market at once because they are accumulating so much that it would move the prices against them. They need to take action carefully. So instead, they buy increments within a specified price range. This causes what we see on the chart as a demand zone or phase of accumulation.
Same for the opposite when they want to sell, they distribute their positions cautiously among markets participants, as they do not want to drive the price lower before they not liquidated at least the majority of their holdings. Once the supply dries out prices usually slip off. Lucky enough for us we can spot these price ranges and areas of interest with a little practice.
Remember, market structure first … always! If you know the areas of support and demand, preferably on higher time frames you are more likely to buy with “smart money” or institutions and sell with them as well before prices dumb and your once in profit position turns against you.
Combined with Support and Resistance, proper risk management the concept of supply and demand can provide you an edge in the market.
How Do We Draw Zones of Supply & Demand?
Now let us take out some charts and start to identify and draw some of these zones of supply and demand. First of all we need to find a starting point. As in most other cases when we want to identify certain things on our charts, we start on the right side with current prices and move left from there. This may sound odd to some of you, as we are all used to read and write from right to left, but we work from most recent prices more and more into the past.
We are looking for the first ranging candle after a strong trend, e.g the first down candle after steep rise. See on the screenshot below the first red candle that marks the supply zone. From there we identify the top of the candle, the wick. This will be our distal line or upper range of the zone. Next we look down to the low of the reversal candle we identified and look for the next candles after that closed outside the wick of our reversal candle. In the example below it happened two candles after and we take the opening (top of the body - for a red candle) for our proximal line or the lower range of the supply zone. There are cases where the next candles do not close below the wick of our reversal candle, but have wicks even lower. In that case we extend our zone until we identify a close outside the wick(s) and move the proximal line up to the open of the candle that finally took out the wick.
Distal line - is always farthest away from the current price, so it is the top of a supply zone and the bottom of a demand zone.
Proximal line - is always closest to the current price and therefore the lower range of a supply zone and the top of a demand zone..
Once a zone is lost and replaced by another we can delete it and start looking for the next one. This is in contrast to S&R. Once the a demand zone is taken out there are no buyers left. Same for the supply zone if the price shoots through all sellers are gone.
Something you will encounter regularly and you can find the example below are overlapping zones of the same kind. As in the screenshot below we have two zones of demand one already tested, but not taken out and another one untested until last week.
Supply & Demand Zones for Bitcoin on a Weekly Chart
Quick summary of the steps drawing supply and demand zones:
Identify a reversal candle after an up- or down-trend
Mark the low (wick) of the candle for a demand zone or the high (wick) for distal line
Look for the first candle closing outside the range of the reversal candle and mark your proximal line on the opening of the candle - be aware the wick might extend over to the next candle if the wick is longer than the ones before but still closes inside the former one
Draw your zone accordingly
Check the screenshots within the article to give you an idea on how draw the zones. It takes a little practice, but in general it is very straightforward and you will start getting used to it. As in most thing practice is the key, start drawing zones and observe how price reacts to those. Trading is not science, it is an art ;)
How can we identify a strong zone of Supply & Demand?
There supply and demand zones more significant or reliable than others. In the following I will list five attributes that make a zone significantly more important than others. The most important one for me are those “fresh and untested”. They are drawn out once price left the are and so far completely untouched by any price action. Markets have long memory and price tends to come to these zones and once it happens larger orders get filled. Check the screenshot above, we drew a zone in July 2021 and it was untouched until a couple of days ago. This makes me optimistic on the current state for Bitcoin and crypto in general, but this is something for the next market update.
So what are the factors that identify a strong zone of supply and demand?
Best are those Untested and fresh
Narrow price range and not many long wicks (As they mean uncertainty and unbalance within the price range)
Less than 10 candles within the zone (It might take a while to determine the trend - but not forever!)
Strong price move once it breaks out or retests it
Fakeouts - breaks to the opposite side of the zones with an immediate reversal - this is a signal that big player are stop hunting to fill even more bags
Detailed Supply & Demand Zones for Bitcoin on a Weekly Chart
How can we trade zones of Supply and Demand?
The part we are probably all most interested in is how we can trade the zones. Actually, it is pretty straight forward and simple.
Place orders right above the zone (for demand) or below (for supply)
Set take profit right below the next supply zone (for a long) or above a demand zone (for a short)
Stop-Loss is set a little bit outside on the opposite of the zone
That’s it!
Of course we can and we should bring in a bit more complexity here as well. What makes this approach advantageous beside the fact that it is simple? It is very easy to identify the risk and reward ratio. We start our trade just outside a box, let it run until the next box and set the stop-loss right outside the zones. You have all parameters together to determine your risk and reward.
Trade Plan for Bitcoin based on Supply & Demand for a Daily Chart
For me I would always aim for a risk and reward of at least 3. Why is that? I keeps from trading each and every zone I draw on the chart and leaves only those with a certain in between and a nice reward in comparison to the risk taken. Same is for the time frame, I tend to trade those on the weekly, daily or 4-hour. But this is up to you, you can bring them down to a 15m or even 5m chart if you feel comfortable with it. But be aware of more volatility or prices chopping around with long wicks in either direction. It makes drawing and trading based on supply and demand zones a bit challenging, as stop-losses may be hit more frequently as on higher time frames (see below).
As in each trading system bring in more parameters, indicators or ideas that fit your style of trading. For example only trade supply and demand if your directional bias is accordingly to your intended trade direction. Read here for more on the directional bias approach. Of course, you can bring even more, like moving averages or momentum indicators like the RSI or Stochastic to give you more confluence in your trades.
Comparison of a Daily drawn Supply Zone to a 4-hour drawn Demand Zone on a Bitcoin Chart
Final Considerations
Markets have long memory and especially large participants are very patient. Price tends to find its way to zone so far untested. Do not trade against the market, but with it.
Follow the path of least resistance. The successful identification of supply and demand zones can help you walk this path. It may take some practice, but in the end will be beneficial.
If you are new to trading and even if you are around for while. Remember to keep it simple. Over engineering often does more harm than good.
And now a few final words my own interest, I try to provide all my content for free and I will stick to it. So, if you enjoy reading my post and find the stuff helpful I would appreciate it if you spread the word and follow me on Twitter, Medium, Telegram and every where else.
Cheers!
