Supply and demand patterns are price action structures that are formed at reversal points and inside the trend.
There are two types of supply and demand patterns: Reversal Patterns and Continuation Patterns.
Traders can choose to trade one or both patterns. In this article, I will show you how to identify these supply and demand patterns and how to trade them.
Peaks and troughs
Price moves in zigzags creating new highs and lows:
During uptrends, price moves higher creating new higher highs and higher lows.
During downtrends, price drops down creating new lower highs and lower lows.
At the extremes, price forms peaks and troughs as it moves over a period of time.
Peaks and troughs are defined as the highest levels and the lowest levels on price charts respectively. These areas are where reversals happen.
Reversal points (peaks and troughs) are price areas where the market changes the trend by moving to the opposite direction of the previous trend.
The chart below shows what a peak and a trough look like:
Reversal patterns are price action structures formed at the extreme highs (peaks) and lows (troughs) of price charts.
These supply and demand patterns are very strong to trade, especially if you are a swing trader. Trading these patterns give you the ability to identify the beginning of a new trend and position yourself to catch big swings in price.
There are two types of reversal patterns: Rally-Base-Drop and Drop-Base-Rally.
The Rally-Base-Drop structure is formed at the peaks where price moves from an uptrend to a downtrend.
The Drop-Base-Rally is located at the troughs or the bottom of the chart where price moves from a downtrend to an uptrend.
The following chart shows these two structures: rally-base-drop at the top of the chart and the drop-base-rally at the bottom of the chart.
1. Identify reversal patterns
When price is over-extended with more than 3 consecutive continuation patterns, price changes direction by creating a reversal pattern.
On the chart below, price started with a supply zone (rally-base-drop) followed by 4 consecutive continuation patterns. At this point, price was clearly running out of steam and started losing strength to the downside.
Then price broke the trendline, created a new demand zone (drop-base-rally) and a new uptrend started at the trough.
Notice how price ignored any continuation pattern after the third one.
Here’s how you can identify reversal patterns:
– During an uptrend:
Price creates W shape patterns at the peaks of the chart.
In A, price creates the 3rd CP and moves up.
In B, price creates a new higher high and forms a new supply zone at the peak of the chart.
In C, price retraces back up to test the 1st CP and drops down.
– During a downtrend:
Price creates M shape patterns (inverted W shape pattern) at the trough of the chart.
In A, price creates the 3rd CP and moves down.
In B, price creates a new lower low and forms a new demand zone at the trough of the chart.
In C, price retraces back down to test the 1st CP and rallies to the upside.
2. How to trade reversal patterns
To trade reversal patterns, we simply wait for price to retrace back to the first continuation pattern to execute our trade.
Let’s take the following example:
On the monthly chart, price is over-extended with more than 3 CPs and creating new all time highs.
On the weekly chart, price broke the trendline and we wait for a full candle (OHLC) to form below the trendline.
On the daily chart, price broke the trendline and created a new supply zone followed by the first continuation pattern.
To trade this W shape reversal pattern, we wait for price to retrace back up to test the 1st CP pattern to short the market.
After the third CP, we stop trading because price has lost strength and price will reverse.
Continuation patterns (CP)
Continuation patterns or CPs are formed within the trend. These supply and demand patterns are usually weak and price tends to ignore them.
CPs are good levels to trade if they are near reversal patterns. After the third CP is formed, price is over-extended and CPs are no longer valid to trade.
1. Identify continuation patterns
Continuation patterns are: rally-base-rally and drop-base-drop types of structures.
These structures are created inside the trend.
During uptrends, price creates a series of rally-base-rally type of structures.
During downtrends, price creates a series of drop-base-drop type of structures.
The following chart shows continuation patterns formed during a downtrend. The CPs are located inside the downtrend.
2. How to trade CPs
In order to trade CPs, we need to make sure that the trend is still valid. If the price breaks the trendline, we don’t trade CPs. As long as the trend is confirmed and price respects the trendline CPs are valid to trade.
Another thing to keep in mind is the number of CPs formed. If price creates more than 3 CPs, it is considered over-extended and CPs are no longer valid to trade.
The best strategy to trade CPs is trade the first 3 CPs formed near the reversal points. After the third CP, price is going to break the trendline and create a reversal pattern.
Often, price creates valid CPs at the beginning of the trend, but never retraces back to test them. This is why it is better to trade the first continuation pattern right after the reversal happens.
In this example, price created an inverted W shape pattern (M shape pattern), started a new uptrend and after 3 consecutive CPs price started to move sideways preparing for a new reversal to take place.
The first CP is a strong zone to trade. Price retraced back to it twice. The second and third CPs are also good zones to trade. After the 3rd CP, price started moving sideways and the trend reversed.
There are two types of supply and demand patterns: reversal and continuation patterns. The reversal patterns are located at the peaks and troughs, whereas continuation patterns are located inside the trend.
To trade supply and demand patterns, you need to identify whether you have a W shape or an inverted W shape pattern, then trade the 1st CP after the first pullback.
After the 3rd CP, you don’t trade because price is over-extended. Instead, wait for price to break the trendline, create a new reversal pattern (W or M), and retrace back to the 1st CP.