Supply and Demand is considered one of the most profitable trading strategies you can use to trade the Forex market.
As we all know, forex is a huge market where traders buy and sell currencies. To become a profitable forex trader, you have to study the main drivers that control and move prices in the market. You also need to be able to identify trading setups and position yourself in advance.
We all agree that price moves due to supply and demand forces; supply drives prices lower and demand drives prices higher. Once you understand the dynamics of these two forces, you will anticipate almost every price movement on any given asset or market.
The Supply and Demand trading strategy teaches you how to identify high probability trading levels where unfilled orders are waiting to be filled. The core strategy is to sell when price hits supply zones and buy when price hits demand zones.
Although it seems simple, many traders fail to implement these simple rules in their trading.
In this article, I will explain the core concept of supply and demand strategy and show you how to correctly implement it to trade the Forex market and generate consistent profits.
Introduction to Supply and Demand
What is Supply and Demand?
The supply and demand concept states that if the supply of a commodity is high and the demand is low, this generates excess which drives the price down. If the supply of a commodity is low and the demand is high, this creates scarcity and then pushing the price higher.
In the Forex market, when the supply for a currency pair is high and the demand is low, this will drive prices lower. If the supply for a currency pair is low and the demand is high, the excess demand will drive prices higher.
For example, during times of uncertainty and fear, investors reduce their exposure in the equity markets and start buying safe haven currencies to protect their investments. The high demand for the US dollar will drive the price of the dollar higher due to the high demand by the investors to buy the US dollar.
Another example is when the Fed (Federal Reserve) decides to increase the interest rates. This will make the US dollar attractive to investors because of the interest rates they will gain. This is also known as the carry trade, where traders buy currencies with high-interest rates and sell those with low-interest rates.
As you can see, supply and demand is a general concept applied to anything that can be traded.
Now let us see how we can identify supply and demand on the chart so we can plan our trades accordingly.
A Supply zone is located above the current price where there is strong selling interest. When the price action reaches this level, the orders get filled and price moves down. Traders are selling at the supply zone and price action reverses to the downside.
A Demand Zone is a price area below the current price where there is strong buying interest. On the chart below, we can see that there was a lot of buying interest in the demand zone. This is most likely caused by a large number of buying orders at this level.
When price reaches the demand level, 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.
Understand Market Balance-Imbalance in Forex
The basic pattern of the Forex market is balance, imbalance, balance, imbalance, etc. The market trades between the established excesses until it either trades above the high excess (breakout above the resistance level) or below the low excess (breakout below the support level).
If the market is balanced, as shown in the chart above, equal amounts of buying and selling are present. The price keeps moving up and down within a range (sideways) creating a distribution.
When buyers or sellers are in control, the market is imbalanced and will move in the direction of the predominant players. If sellers are in control, the market will move down and if the buyers take control, the market will move up.
To better understand this concept of balance and imbalance, let’s move to the chart and see how we can apply these key points.
In the chart below, the blue arrows show balanced areas. These balanced areas are areas where both buying and selling activities occur at the same time because both buyers and sellers are comfortable around this price range. Notice how price moves horizontally.
Once the market moves from a balanced state to an imbalanced state, price leaves the area with large candles. This represents the imbalance, which means that one of the players exceeds the other. From the left side of the chart, sellers exceed buyers and prices dropped like a rock falling from a cliff.
The market then enters a balanced state waiting for the price to take a directional move to either the upside or the downside area. Price went up and we have a balanced area, etc.
Now, on the right side of the chart, the price dropped in rapid fashion and then continued dropping with small candles. This shows that the market participants are seeking a fair price for the balanced rotations to occur.
This is the general cycle of the market; balance, imbalance, balance, imbalance, etc.
In supply and demand strategy, we focus on spotting these areas of balance. Because we want to place our order in these areas and profit from the imbalance that moves the price in a directional move, and thus, making a profit.
How to Identify Supply and Demand Zones
We start by identifying the current price then we look to the left until we find a big strong move up or down.
Here’s how you do it:
- Identify Current Price
- Look to the Left to find ERC in last drop or rally
In this step, we need to find an ERC type of candle. ERC simply means an Extended Range Candle, it is a candle that has a large body and small or no wicks. Here’s how an ERC type of candle looks like:
- Origin of the Move
Once we identify an ERC type of candles and we have either a drop or a rally in price, now we have to find the origin of that move.
This origin will form the base of our supply or demand zone. Let’s look at an example:
In this example, we start at current price and we look left to find a drop or a rally in price with at least one ERC type of candles. Once we identify an ERC, we identify the origin of the down move. The origin is what we call a base.
The base is what we need in order to draw the zone.
Now that we know how to identify supply and demand zones, we need to learn how to draw our supply and demand zones.
The Different Structures of Supply and Demand Zones
There are 2 types of structures or patterns that we need to learn: 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.
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.
How to Draw Supply and Demand Zones
How to Draw Supply Zones
To correctly identify a supply zone, we look up and left from current price to find strong bearish candles with large bodies. The chart below shows the departure of price from the base. Starting from the left of the chart, price rallied up in a nice uptrend and paused for a short time creating a nice base structure with three candles. Then, price dropped creating long bearish candles confirming a strong market imbalance around this supply zone. This structure is what we call a rally-base-drop.
As price keeps retracing back up to this supply zone, we can take advantage of these retracement to place our trades around the basing area. Notice how price retraces up and drop as soon as it approaches the supply zone without piercing its proximal line. This means that large piles of unfilled orders are placed around this supply zone.
Now we need to assess whether the basing structure is valid or not. The structure of the base is crucial to successfully select the best supply zone to draw your lines. Ideally, we need to choose a base with less than six candles to be considered an excellent base structure to trade.
The last step is drawing the zone using two horizontal lines (distal and proximal lines). The proximal line is near current price at the bottom of the basing bodies excluding the tails. The distal line is located above the basing candles including the tails.
How to Draw Demand Zones
In order to identify a demand zone, we need to find a nice rally in price or a group of bullish candles and also a base with less than six candles. The chart below shows how the price has dropped down, paused for a little time forming a consolidation structure (base: 1 candle), then the price rallied up from the base with very long bullish candles creating a demand zone.
So knwo that we know how to place both lines, let’s go through an example:
In the supply zone, we have one candle at the basing structure. To draw the supply zone correctly, we place the distal line at the highest wick of the base. Then we place the proximal line at the low of the body of the base as shown in the chart above.
Price moved down creating a demand zone with three candles at the base. To draw the demand zone correctly, we place the distal line at the lowest wick of the base. Then we place the proximal line at the highest body of the base candles.
If you decide to include both the high and the low of the wicks, you have increased your risk by making your stop larger than it should be.
If you decide to include only the highest wicks for the supply zone and only the lowest wicks of the demand zone, you are decreasing your odds of getting your order filled by the market price.
Again, when drawing supply and demand zones, you have to keep in mind both your risk exposure and your odds of making money.
How to Trade Supply and Demand
We buy at demand zones and we sell at supply zones. This strategy is pretty straight forward. All you have to do is identify fresh supply and demand zones to trade. Then place your limit orders at the proximal line and your stop loss at the distal line. Now and wait for the price to return to the selected zone to trigger your orders.
Here are some examples:
In this chart, we have two demand zones and one supply zone. For supply zone: price rallied up, paused for a little time and dropped with big candles. So we have a great imbalance at this price level. We draw our zone and we place our order and wait for the price to come back and retest this zone. Price came back twice and our sell orders were a success.
At the same time, when the price dropped from the supply zone, it created two demand zones in its way up to retest the supply zone. Price rallied up and paused creating a rally-base-rally type of zones. We placed our buy orders in these two zones. Each time the price tested our demand zones, it triggered our buy orders. Look how the price is attracted to these zones like a magnet.
In this chart, the price dropped and reacted to an opposing demand zone on the left side of the chart and rallied up creating a new demand zone. We placed our buy order at this price level and waited for the price to come back and retest the demand zone. Price came back, triggered our order and when up.
The price rallied up, paused creating a base and dropped down. We draw our supply zone and place our sell order and wait for the price to come back. The reason why we placed only one sell order is that when price retested the supply zone the tail of the candle pierced the supply zone. This is a sign that this supply zone is used up and the probability of another sell order to work out will be slim.
In this chart, the price created a rally-base-rally. Usually, I don’t focus too much on rally-base-rally and drop-base-drop types of zones because they are located within the trend and trades fail most of the time. So I prefer focusing on the structures that develop at the reversal (drop-base-rally and rally-base-drop). These are very reliable and strong structures to trade.
The price created a rally-base-rally type of structure. We draw our demand zone and waited for the price to test it and trigger our buy order. Price did come back, tested the zone and rallied up as planned.
Sometimes if you are not sure if the zone will yield a successful trade, you could wait for the price to test the zone and gives you some bullish or bearish evidence before placing your order. That way you could decrease your chances of entering a losing trade.
Again, I prefer structures at reversal points because they are powerful and chances of success are high compared to within the trend structures.
In this example, we have another within-the-trend structure. I wanted to show this trading setup because as I mentioned in the previous example, these structures are not very strong.
But you can still trade them, especially if they are located at the beginning of the trend. Here the base is near the reversal point. This is what made this zone tradable.
Otherwise, if the drop-base-drop was located farther down of the trend, I won’t consider it because the trend could reverse at any time and the price will go through the zone and keep going up.
How to Identify Supply and Demand Curve
To identify the curve, we need to look at the current price and identify the nearest supply and demand zones in control.
The distance between the two proximal lines of supply and demand zones we just identified forms the curve.
On the chart below, we locate the current price and we look up and down to identify the nearest Supply and Demand zones in control.
Now that we have drew the zones, we see clearly that the price is located near the demand zone. We say that price is low in the curve.
When price located low in the curve, we buy only.
In the following example, the price is located near the supply zone in control. Here, we only think of selling as the price is high in the curve.
When price is located at half the distance between supply and demand zones, we trade in the direction of the prevailing trend.
We say that the price is at the equilibrium. Here’s an example:
As shown on the chart, price is located at half the distance in the curve. This is called the equilibrium where buyers equals sellers.
Usually price keeps moving sideways in this area in the curve until one of the players exceeds the other one.
If buyers exceed sellers, we will have an uptrend movement to the upside pushing price higher in the curve.
If sellers exceed buyers, we will have a downtrend movement to the downside pushing price lower in the curve.
Why is it Important to Identify the Curve?
This is what separate the winners from the losers.
Professional traders know that when price is high in the curve, they need to sell to the retail traders that are excited to see an uptrend move. So the retail traders jump on the wagon and start placing buy orders.
Professional traders use the high liquidity provided by retail traders to short the market and move price lower.
When retail traders see price dropping rapidly, they think this is the moment to short the market. Again, professional traders jump on the opportunity to place their buy order as price enters low territories in the curve signaling a nice bullish reversal to the upside.
This is why it is important to identify the curve before placing any order.
As a general rule, we buy when price is low in the curve and at the demand zone, and we sell when price is high in the curve and at the supply zone. When price is at equilibrium, we trade with the prevailing trend.
Odd Enhancers to Find High Probability Zones
Now let’s discuss the main four odd enhancers that will help us filter our zones and choose only those supply and demand zones that have high probability of success.
We will give a score for each odd enhancer so that we get a final score.
As a rule of thumb, a final score of 10 out of 10 means that we will place a limit order and wait for price to hit our entry target.
A final score between 8 and 9 means that we will use a market order to enter the trade. A final score below 8 simply means that we have no trade.
Odd Enhancer 1# Strength of the Move
Good supply and demand zones have a strong move out of the zones. Here we are looking at how the price left the zone.
Did the price leave with strong large candles or many small candles?
We will score this from 0 to 2 point maximum.
Here’s an example: price left the supply zone with strong bearish candles to the downside and the score is 2.
Look how price left the zone. This zone has a score of 0 because price left with small candles. Now look how price retraced back up and went through this supply zone.
As a trader, you should avoid trading weak zones because price will ignore it and pass through it.
Odd enhancer 2# Time Spent at the Zone
The second odd enhancer that we look at is the time that price spends at zone. Good zones have between 1 to 6 candles in the base. Beyond 6 candles the zone might be weak and therefore, resulting in a losing trade.
Odd Enhancer 3# Fresh Levels
The third odd enhancer is to check whether the zone is fresh or not.
A fresh zone is a zone that has not been tested by price. As price keeps coming back and testing the zone, the probability that this zone will work decreases.
After a second retracement to the zone, it is better not to consider it because there might not be enough supply to push the price lower again.
Here’s an example:
In the first retracement, the price tested the supply zone and moved down, the same happened in the second and third retracements. After the 3rd retracement, price broke above the supply zone as no more supply was found there.
Notice that price penetrates deeper inside the supply zone with each retracemnet. This is a good signal that shows whether the zone is still valid or not.
Odd Enhancer 4# Reward-to-Risk
The last odd enhancer is the reward-to-risk ratio. We need at least a ratio of 1:2 to consider the zone as valid for trades.
On the chart below we have a supply zone that has a score of 10 out of 10. Price created a nice drop-base-drop with large ERC type of candles. This shows the strength of the supply zone. We also have a nice reward-to-risk ratio of more than 1:3 giving us a good winning opportunity if price retraces back up and test the supply zone.
A score of 10/10 means that we will place a limit order at the proximal line of the supply zone and a stop loss order at the distal line. And wait for price to retrace back up.
Indeed, price went back up and hit our limit order and went down.
In the next example, we have a supply zone with a score of 8.5/10. The score is between 8 and 9 so we could either wait for price to retest the zone to place our order or wait for it to penetrate the zone and reverse back down out of the zone to place an entry.
Here we have a score below 10 and the price has already tested the supply zone so the probability of success is weak and the price might break above the supply zone.
This is why we wait for price confirmation before we place our entry.
Price did break above the zone and went to test the higher supply zone because it has a higher probability of success. This is why we should focus more on trading reversal patterns rather than continuation patterns.
Now, let’s take a look at a trading opportunity where we have only one zone in control.
On the monthly chart, we identify a supply zone above the current price.
Here in this example, we don’t have a clear demand zone where we can draw our zone. As the price keeps making new lows, we can only use the supply zone and trade with the trend.
On the weekly chart, we draw our weekly supply and demand zones as shown in the chart below. The price creates a nice rally from the weekly demand zone and now approaching the weekly supply zone.
This supply zone is considered very strong. The strength of the move out of the supply zone shows that this zone has a large pile of unfilled orders.
The overall trend is down. Price has created a series of lower highs and lower lows, which confirms the downtrend movement.
Now, we move to the daily chart where we will execute our trade. We identify the daily supply and demand zones around the current price and we look for a zone to place our limit order and our take profit.
Price is approaching the daily and weekly supply zones. We expect the price to test these overlapping zones and move down to test the daily demand zone.
Our sell limit order is placed at the proximal line of the daily supply zone. The stop order is placed above the distal line of the daily supply zone.
Price tested the overlapping supply zones on the daily chart and moved down to test the demand zone as shown in the chart below.
The core concept of trading is to align yourself with big players in the Forex market. As retail traders, we are significantly small that we all can’t even move the price half a basis point. This is why it is crucial to learn how to approach the market and with what tools.
Supply and Demand strategy is one of the best tools available to the general public to trade the FX market and mimic the professional trading approach to become consistently profitable in the long run.
To sum up:
- Supply drives price lower,
- Demand drives price higher,
- The balanced area develops horizontally,
- The imbalanced area develops vertically,
- There are two kinds of prices: fair (balanced area) and advantageous (imbalanced area),
- Short-term traders want a fair price; long-term traders want an advantageous price,
- The market moves (imbalanced area) up or down until it brings in an opposite response. The opposite response stops the directional move and defines the range (balanced area),
- Then the market trades within this range until it trades above or below the balanced area.