In order to identify supply and demand curve, we follow a 3 step process that helps us determine the location of the price in relation to supply and demand in control.
These 3 steps are:
- Locate the current price,
- Look up and down to identify the closest supply and demand zones,
- Divide the area between the two proximal lines into 3 equal zones,
The reason why we determine the curve is to avoid buying high and selling low. In other words, buying at supply zone or selling at demand zone.
This step is crucial when trading forex using supply and demand. Our goal is to trade with the trend, not against it.
By identifying the supply and demand zones in control on a larger time frame, we are able to better position our trade and avoid getting stopped out of a good trade.
Supply and demand are two dynamic forces that establish market prices. These forces are driving prices up or down based on who’s in control.
For instance, if supply exceeds demand, price tends to go down as more sellers are interested in selling instead of buying the asset or product.
If demand exceeds supply, price tends to go up as more buyers are interested in buying instead of selling the asset or product.
In forex, supply drives currencies down and demand pushes them up. For example, if the European Central Bank (ECB) decides to lower its interest rate, investors sell the Euro because of the low interest yield. This creates a bearish momentum across all euro pairs as the currency is weakened by the change in interest rates.
The lower interest rates creates a high supply and low demand that drives the euro down according to the law of supply.
In the case of high demand and low supply would be the ECB increasing the interest rate making it stronger enough to shift the curve from high supply to high demand and therefore, pushing the euro higher as more buyers are interested in buying.
The curve is basically a tool that traders use to determine whether the price is located near a higher time frame supply or demand zone.
This is very important as we want to buy low and sell high to make profit.
Identify supply and demand curve
To identify supply and demand curve, we use a larger time frame to draw our zones in control and determine the location of the price on the curve.
Step 1: Choosing your higher time frame
The multiple time frame analysis consists of analyzing at least 2 to 3 different time frames of the same asset or pair to construct a bigger picture about the the long-term trend. We want to trade with the trend, not against it. The MTF allows us to align our trades with the higher time frame trend. Remember, the larger time frame always wins.
The rule states that when you choose your time frame combination, the higher time frame needs to be 4 times greater than your intermediate time frame and so on. For example, if you want to swing trade, your higher time frame would be the weekly chart. The intermediate time frame would be a daily chart because there are five days in a trading week. The lower time frame wuold be the 4 hour chart.
In this article, we’re going to use the monthly chart as our higher time frame, the weekly chart as our intermediate time frame and finally the daily chart as our lower time frame.
Step 2: Identify supply and demand in control
The second step is to determine who’s in control: buyers or sellers.
As we open the monthly chart, we start by locating the current price. Then, we identify the closest supply and demand zones to the current price.
From the chart below, we can see clearly that price is near the higher time frame demand zone.
The next chart shows the current price located almost in the middle of the curve between supply and demand in control. The way we trade this market is to move withe the prevailing trend. Here we are in an uptrend, we can still buy as long as the lower time frames give us good profit margin to make money. Otherwise, we don’t diddle in the middle.
Step 3: Draw the curve
The third step is to divide the area between the two proximal lines into 3 equal areas. You start by drawing the closest supply and demand zones, and you divide the distance between them by 3: High, Low, and Equilibrium.
There are two options to divide the curve area. The first option is simply to count how many pips there are between the two proximal lines and divide them by 3.
The second option is to use the fibonacci retracement tool to identify supply and demand curve without having to divide the area manually.
To use the fibonacci tool, you have to modify the settings to get exactly 3 equal areas on your chart:
- change the fibonacci levels to the following: 0%, 33% (0.33), 66% (0.66), and 100% (1).
Now that you changed the fibonacci settings, you can draw the curve from the proximal line of the supply zone to the proximal line of the demand zone.
The fibonacci tool will divide the are into 3 equal zones automatically.
How to trade using the Curve
On the larger time frame, the curve serves as an indicator as to whether the current price is high, low, or in the middle between supply and demand in control. Based on this information we can decide whether we buy, sell, or do nothing.
Here are the different trading scenarios based on the curve:
- When price is VERY HIGH in the curve (inside the supply zone), we SELL only.
- When price is HIGH in the curve, we SELL only.
- When price is VERY LOW in the curve (inside the demand zone), we BUY only.
- When price is LOW in the curve, we BUY only.
- When price is at EQUILIBRIUM, we have 2 options: either trade with the prevailing trend or we don’t trade.
Let’s put everything together and see how we can identify supply and demand curve and plan our trade accordingly.
The first thing we do is to begin with the larger time frame to determine the location of the current price and the supply and demand in control. This gives us the frame work to look for trading opportunities.
We draw the closest supply and demand zones and use the fibonacci tool to divide the area into 3 equal levels or zones as shown on the chart below:
The current price is located between the LOW and EQUILIBRIUM areas in the curve, which means that we can only buy as long as the trend is up.
On the weekly chart, price broke the trendline and created a new supply zone. Then price moved down and created a new demand zone nested inside the monthly demand zone.
On the monthly chart, we have price at low/equilirbium in the curve and the trend is up.
On the weely chart, price is moving sideways with a weekly demand nested inside a monthly demand zone.
If you think of selling when price tested the weekly supply zone, then you are trading against the higher time frame trend. As we said in the beginning, the higher time frame always wins. Here we should avoid selling at weekly supply because the trend is up and the profit margin is less than 3:1 reawrd-to-risk ratio.
Instead, we wait until price hit either the monthly or the weekly demand zone to go long.
As we can see, price went back down to the monthly/weekly demand zones and rallied to the monthly supply zone.
As long as we trade with the long-term trend, we are safe.
When price is near the higher time frame demand zone, we buy only.
At this level, buyers are interested in buying more and pushing the price higher. If we sell at lower time frame supply zones, we simply giving free money to the market.
Here’s another example:
On the monthly chart, price is High in the curve. This means that we only SELL fresh supply zones on lower time frames.
On the weekly chart, price is moving up creating new higher highs and new higher lows. We also confirm the trend using the trend line connecting the two higher lows together to draw the trend line.
On the same time frame (weekly chart), we draw our supply and demand zones to align our views with the monthly chart (the higher time frame). We have a supply zone nested within the monthly supply zone. This means that this weekly supply zone has a high probability of success because it overlap with the higher time frame zone.
Same thing for the demand zone down at the bottom of the chart. These nested or overlapping zones have high probability of success because the higher time frame zones are more powerful than the lower ones.
Now that we know the price is high in the curve and the trend is up, we need to find a supply zone to place our entry and stop orders accordingly.
We don’t buy at demand zones because price is high in the curve. Price is near monthly supply zone, which means that soon price will reverse down and pierce all the demand zones that are up in the curve.
To do that, we can either use the weekly chart or simply use the lower time frame to find a suitable entry zone. If the weekly zone is clear like in this example, we can just stop here and place our entry right at the proximal line of the weekly supply zone. But if the weekly zone gives us a large stop that we can tolerate or the zone is not giving us a clear entry point, we can move down to a lower time frame.
On the lower time frame (daily chart), we have a nested daily supply zone within a weekly supply zone. This is a high probability zone to trade. We place our entry at the proximal line and place our stop order above the distal line. The profit margin is good as we have a 3:1 reward-to-risk ratio.
For the exit we place our take profit at the opposing demand zone.
Price hit our entre and dropped all the way down to our target giving us a nice 3:1 profit.
Notice how the risk changes from monthly to daily supply zones. If we were to trade the monthly zone, we would have placed a large stop loss and price would pierce almost half of the zone before reversing back down compared to the weekly and the daily supply zones.
When we identify supply and demand curve, we know exactly what we should do. We know that we need to buy low at demand zone and sell high at supply zone and not the way around.