The two components of the market – demand and supply are the push and pull of the stock market which reflects the change in price, availability, and desire for security.
The dynamics between the two can help traders in identifying an opportunity during trading. The supply and demand zones show liquidity at a specific price.
Before we jump on to the blog, understand that these zones are responsible for driving the market and helping investors in making a purchase or sales decision.
According to Wyckoff's Method of trading and investing, supply and demand determine the price direction. To understand what is wyckoff theory, you should learn about the historical law of demand and supply, but it still works in the modern era.
The law says that accumulation happens to create demand more than supply, and it enters an overbought region where the distribution area begins. Eventually, the distribution leads supply to become greater than demand.
A trader must understand each supply and demand zones while moving forward to trade in the stock markets. Before understanding types, and indicators and drawing the zones, you should understand each zone.
2.1 Supply Zone
A supply zone is a zone where there is high liquidity in a price area and traders usually trade using sell orders.
The supply zone has the highest selling potential which is present above the current stock price. When the stock price hits this level, several sell orders get completed and bring down the price.
The chart presents the supply zone where the price is reaching the supply or selling zone and then going back down. It becomes a cycle while filling the unfulfilled orders.
2.2 Demand Zone
The demand zone is a price area in the stock where there is a high demand for the stock and buyers are ready to purchase at different levels. The demand zone is present below the current price level and has the highest buying potential.
As a trader, you should know that accumulation happens in a buying zone, and in this case, it is the demand zone where bullish trends are taking place.
As per the chart above, the demand zone shows upward movement, and it keeps moving upward until the orders are filled.
How to Spot Supply Zone?
Open a stock’s chart
Spot the previous high on the chart
Spot the start position of the previous strong downtrend
Draw two horizontal parallel lines to mark the supply zone
How to Spot Demand Zone?
Select any stock’s chart
Identify the previous low where the previous strong rally commenced
Identify the start position of the uptrend
Draw two parallel lines to mark the demand zone
Before we dig deeper into understanding demand and supply zones, let's figure out why it is important to configure these zones in technical analysis.
A trader should know that demand and supply zones help them to make a purchase or sale during market hours.
Demand and supply zones drive the market in a certain direction and using technical analysis traders can identify the direction.
A distribution zone is a zone where the price creates a base and suddenly starts its downward movement as a price drops. It indicates the pressure of sellers in the markets from the supply zone.
The accumulation zone indicates a high demand for the stock and a positive movement. There is a buying pressure seen in the accumulation zone which is also known as the demand zone.
The supply and demand zone is a broader area in comparison to support and resistance which should be considered by traders during entering or exiting a trade.
6.1 Continuation Pattern
A continuation pattern is a situation in a stock's chart which is created using two types – Drop-base-drop (DBR) and Rally-base-rally (RBR). In the creation of a supply and demand pattern, DBR and RBR are observed.
Drop-base-drop: DBR is a price pattern where the price drops for a moment to create a base and then continues the downward movement.
Rally-base-rally: RBR is a price pattern where the price rallies to create a base and pauses for some time, then continues to an upward movement.
The connection between DBR and RBR in demand and supply zone is that it forms a continuation pattern to help traders understand the rise or fall in price.
In supply zones, the price drops significantly and continues to follow DBR price movement whereas, in demand zones, the price rallies up and creates a RBR structure using long candles in a continuation pattern.
According to traders, the reversal pattern has a higher strength of success in comparison with the continuation pattern.
Let's learn about the reversal pattern in demand and supply.
6.2 Reversal Pattern
A reversal pattern is a price change situation where the price trend reverses downward or upward. We need to understand the patterns clearly through DBR and RBR movement.
In this case, DBR incurs a price drop where it creates a base structure but reverses into the upward direction and continues the rally.
Similarly, RBR rallies in an upward direction and creates a base, however, it reverses the movement into the downward direction and causes a price drop.
When you observe the supply zone, the price will seem to rally up but in a reversal pattern, the price will fall significantly. In the case of the demand zone, there will be a clear indication of the downward movement of price, although a reversal pattern will create a base and develop an upward movement.
7.1 Breakout Strategy
A breakout strategy is a supply and demand trading strategy that makes a directional movement. Generally, traders use this strategy to make an entry into the market.
Using a candle breakout strategy, you can also anticipate the chance to opt for a short trade after the price reverses towards the demand zone. A retracement towards the demand zone can help you identify the breakout.
A forex trader looks for these trades using a breakout strategy because a favourable entry is essential for them to make profits. One should remember to stop buying beyond the demand zone and stop selling beyond the supply zone for safe trading.
7.2 Risk Management Strategy
Risk management comes from considering planning your trades, diversifying, and understanding the bottom line of entering a trade.
Support and resistance are the narrow versions of demand and supply which generates awareness of managing our risks through the horizontal lines on the chart. It is used to put a stop to ongoing positions and save traders from risky trades.
A trader understands through demand and supply where and when to place the trade. Traders with a risk appetite can trade beyond demand and supply zones, although it is advisable to formulate the risk and take a trade on the zones marked for a particular stock.
7.3 Range Trading Strategy
A trader observes and trades through a range trading strategy when the market moves consistently between two price levels for a certain period. Using this strategy, a trader can easily identify the short and long entries in a long-time frame chart.
We use range trading to understand at what points how many trades are being taken so that a clear identification of the trend of the stock can be generated.
Do you know that markets are in a trend only 30% of the time, which makes it critical to identify a range trading strategy? A trader identifies the supply and demand position during the trend to spot the sell entry and buy entry in the stock.
As per the figure above, a trading range has been identified with demand and supply points which can be taken as buying range and selling range respectively.
Our aim for this blog was to explain the importance and use of supply and demand in technical analysis. We conclude that traders need to understand the importance of the zones before placing their trades, especially in forex markets where there are price fluctuations.
The supply and demand zones follow drop-base-drop and rally-base-drop structures which is important for you to keep in mind. The concept of demand and supply is like support and resistance, only that these zones are broader.
Of course, there are numerous other ranges and strategies that a trader might use, but supply and demand zones are crucial for each setup to manage the risk. It is summed up that the entry and exit zones through demand and supply can assist traders in taking advantage of a new trend.
Look for a supply zone for a sell order
Look for a demand zone for a buy order
Accumulation zone = buyer’s zone = demand zone
Distribution zone = seller’s zone = supply zone
In a continuation pattern, a DBR and RBR will continue to follow the same trend.
In a reversal pattern, a DBR and RBR will perform to reverse the trend of the stock
Use a breakout strategy to make an entry into the market
Use a risk management strategy to trade within the support and resistance zone and minimize the risk.
Use a range trading strategy to analyse the short and long trends formed in a longer time frame chart.