There are 3 simple steps you need to follow to identify supply and demand zones in Forex:
- Start at the current price,
- Look to the left to find explosive candles,
- Identify the origin of the move,
When it comes to trading the forex market, many traders rely heavily on technical indicators and market sentiment to spot shifts in momentum. Others, simply trade market imbalances by searching for supply and demand zones.
These zones are price levels created by banks and institutions where unfilled orders are waiting to get filled. The whole concept of supply and demand is centered around finding smart money orders on a price chart. Because they have the power to move prices, they are the ones you should trade with.
In order for you to trade market imbalances, you need to identify supply and demand zones correctly. To do that, there is a set of rules you have to follow to help you find these zones on any asset you want to trade.
In this article, I will show you step by step how to identify supply and demand zones correctly on a price chart. I will also go through their different structures and show you live chart examples at the end of the article.
So let’s get started!
What is a Supply Zone?
A Supply zone is a price area above the current price where there is strong selling interest. When the price reaches this level, the orders get filled and price moves down.
Traders are selling at the supply zones.
As you can see on the chart below, price rallies to a certain level or zone, pauses for a little time then retraces back down. As long as unfilled orders are sitting there, price will keep coming back to this supply zone until all orders get filled.
What is a Demand Zone?
A Demand zone is a price area below the current price where there is strong buying interest. On the chart below, we can see a lot of buying interest in the demand zone. This is most likely caused by a large number of buying orders at that level.
Traders are buying at the demand zones.
When price reaches the demand zone, some orders get executed and the rest gets absorbed. What you will see on the chart is a sharp move to the upside as orders get filled.
In the next section, I’ll show you how to identify supply and demand zones. But first, we need to learn the two main patterns to know exactly what we are looking for when analyzing a price chart.
The Different Structures of Supply and Demand Zones
There are 2 types of structures or patterns: Reversal and Continuation Patterns.
These reversal patterns are chart patterns that are formed when the trend reverses from up to down or down to up. We have two structures:
- Drop-Base-Rally: in this structure price is moving in a downtrend creating a drop in price followed by a base structure than a rally in price to the upside.
- Rally-Base-Drop: in this structure price rallied up and creates a base structure followed by a big drop in price to the downside.
These reversal patterns are strong and price tends to respect them.
Here’s an example:
We have a supply zone on the left side of the chart where price rallied, paused for a while and then dropped creating a rally-base-drop structure. Notice how price left the basing structure. The long bearish candles at the drop showed how strong the imbalance was at that price level.
The next two structures are demand zones where price dropped, created a base then rallied up in strong fashion.
These price structures are:
- Drop-Base-Drop: price drops and forms a base structure then continues moving down.
- Rally-Base-Rally: price rallies up and forms a base structure then continues moving up.
These continuation patterns are found inside the trend. They tend to be weak zones to trade because most of the time price tests these structures and breaks through them.
That is why we focus only on reversal patterns because they have good odds of success compared to continuation patterns.
Here’s an example:
Next, you will learn the three steps you need to follow to help you identify supply and demand zones correctly.
How to Identify Supply and Demand Zones?
In order to find supply and demand zones, we need to identify market imbalances. These imbalances are big price movements to either directions (up or down) based on supply and demand.
As we can see on the chart below:
- When demand exceeds supply, price rallies up creating big green candles.
- When supply exceeds demand, price drops down with big red candles.
These price movements are showing us where the imbalance is located on a chart. This is important to understand as it is key to find high probability supply and demand zones.
The key thing to remember is to look for big and large candles. These explosive price candles are known as ERC (Extended Range Candle).
Now that we explained briefly the market imbalance, here are the three steps you should follow to find supply and demand zones.
Step 1: Identify Current Price
We start by identifying the current price then we look to the left until we find a big strong move up (for supply zones) or down (for demand zones) as shown on the chart below.
Step 2: Look to the Left to find ERCs
In this step, we look left from current price to find ERCs. These candles have a large body with small or no wicks. The size of the body represents more than half of the candle’s range. If the body’s length equals the length of the wicks it is not an ERC.
Here’s how ERCs look like on a price chart:
Step 3: Origin of the Move
The last step consists of identifying the origin of the big move in price. As we can see on the chart, price moved up with very small candles, paused for a little while before dropping down with at least two ERCs.
This origin will form the base of our supply zone.
The base is what we need to draw the zone as we will see later on in this article.
Professional and Novice Gaps
Gaps are extremely useful price action structures that enable us to identify supply and demand zones. They are great indicators of market imbalances as they indicate clearly where the market is going so that we can trade accordingly. They are leading indicators for trading supply and demand imbalances.
In this section, we will explain the main two types of gaps that will help us identify supply and demand zones easily.
What is a Gap?
By definition, a gap is an empty space between two candlesticks where price either rises or falls from the previous candle’s close with no trading occurring in between. They also represent big supply and demand imbalances where either supply exceeds demand or demand exceeds supply.
This is important for us as it shows exactly where the imbalance is located on a price chart.
A gap up is a gap that occurs when the lowest price of a candle is above the highest level of the previous candle.
A gap down develops when the highest price of a candle is below the lowest price of the previous candle.
Gaps are common when major economic news or an event causes market fundamentals to change when markets are typically closed. They are usually found at the open of the market on Sundays.
A gap is considered closed or filled when price comes back and fills the entire range of the gap. Once price fills the gap, it reverts to the direction of the prevailing trend.
Based on the type of gaps, we can anticipate either a beginning of a new trend or a reversal of a previous trend.
In supply and demand, there are two types of gaps that are important to us: Professional gaps and Novice gaps.
A professional gap is a gap that occurs in the opposite direction of the previous trend. The pro gaps are formed at the beginning of the moves and extend it.
Here on this example we have a professional gap formed in the opposite direction of the prevailing trend (downtrend). Price retraces back down to fill the pro gap and reverses up. This kind of gap signals a market imbalance created by professional traders. This indicates a great demand zone to trade once price returns to fill the gap.
A novice gap is a gap that occurs in the direction of the prevailing trend. A novice gap tends to form at the end of the trend, which leads to a reversal.
The following example shows how novice gaps are formed on a price chart. As price rallied creating a gap in the same direction of the prevailing trend (uptrend) then it reversed back down. As we said earlier, novice gaps are located at the end of the move and on this chart we can see clearly that move ended a candle after the gap. Notice also that we have a supply zone where the reversal started.
It is important to understand these two types of gaps when trading supply and demand because they give us an important piece of information as to where the market is willing to go next.
In this example, we have a drop-base-drop structure where price dropped, created a basing structure and then continued dropping to the downside.
As we said earlier, this is a continuation pattern located inside the current trend. Notice how price reacted when it came back to test this supply zone, it dropped again telling us that more unfilled orders were still in this zone to get filled.
On the chart below, we have an example of a drop-base-rally type of demand zone. This is a reversal pattern where trend shifts from a downtrend to an uptrend. This type of patterns is very strong.
The price dropped creating a basing structure then rallied up forming a demand zone where buyers exceed sellers. When price came back to test it, it went up again as more unfilled orders get filled.
Another example, we have a rally-base-drop structure where price rallied up creating a basing structure then dropped down. This is a reversal pattern where sellers exceed buyers.
This is a very strong supply zone to trade. When price returns to test this zone, it will go down as more unfilled orders get absorbed.
Here is an example where we have a drop-base-rally demand zone followed by a novice gap. The gap here on this chart helps us identify supply and demand zones where buyers exceed sellers. Price created the demand zone and returned to test it with a novice gap.
This gap gives us an indication of a potential reversal in the previous trend.
The last example shows a rally-base-rally followed by a rally-base-drop, a drop-base-rally, and finally a rally-base-rally structures.
You need to train your eyes to spot these price levels. Here you can see that there are many supply and demand zones to identify and trade to make money. By following the 3 steps you will be able to identify supply and demand zones, place your orders and wait for price to return to test them.
The entire concept of trading supply and demand consists of identifying high probability zones using the three steps outlined in this article.
To identify supply and demand zones on any price chart, all we have to do is to search for big candles. These ERCs are the ones showing us exactly where smart money is located on the chart. Once we identify these candles, we can work our way up or down to find the origin of this big move and draw our proximal and distal lines accordingly.
Another way to identify supply and demand zones is the use of professional and novice gaps. These price action formations give us a good indication of where market imbalances are located and what the market is willing to do next: either continue in the direction of the prevailing trend or reverse and start a new trend.
In the next post, I will show you exactly how to draw your supply and demand zones that you identified using the three step rule explained in this article.