What is Supply and Demand?
What are the laws of Supply and Demand?
What is Supply and Demand trading?
How do we use Supply and Demand trading in forex and other financial markets?
Supply and Demand is the heart of a market economy [Capitalism]. Since market economy is based on exchange of goods and services for a value, for it to function there has to be some goods and services on offer [supply] and people who are willing and able buy them [demand]. Supply and Demand in textbooks look as two separate things for study purposes but in reality they are strongly interconnected. One cannot exist without the other.
In an ideal open market, prices are defined by supply and demand, creating a base framework for allocating resources in the most efficient way possible. However, in reality this is not always the case. Monopolies and regulators in certain sectors or systems can define prices as they like regardless of buyers. Prices may also be manipulated by speculators unnaturally thus overriding basics laws of supply and demand.
As it can be seen on the above illustrations, suppliers will produce more when prices going up while buyers will increase their demand when prices are going down. A clear conflict of interest suppose to create a healthy and efficient market.
That's in theory, but in reality we know that there are situations when prices are going up but suppliers will not increase their output unless there are healthy competition. Or buyers will not increase their buying even if prices are going down when they don't have a buying power.
The Textbook Law of Supply
1. In order to maximize their profits, suppliers [producers] will be offering more products and services for sale at higher prices.
2. The supply increases as prices increase and decreases as prices decrease.
3. At certain price levels, when there is a good enough profit margin, suppliers will increase their productions without demanding higher prices in order to increase profits.
The Textbook Law of Demand
1. In order to save some money, people will buy more products at lower prices.
2. At a lower price, more people can afford to buy more goods and services more frequently, than they can at a higher price.
3. At lower prices, people tend to buy some goods and services as a substitute for more expensive ones.
Putting Supply and Demand together
For the purposes of simplicity, Supply and Demand lines are drawn as straight lines. In reality they are curved.
Equilibrium represent the ideal quantity and price match. It's the intersection point where market reached optimum efficiency. For example we have 20 products for sale and 20 people willing to buy. No wastage whatsoever. However, in reality equilibrium cannot be sustained. It's just a temporary point that may be reached from time to time for a brief period. For the life and everything else in this universe to continue we need minus and plus. When all things are equal nothing will happen.
Sellers and buyers needs to keep fighting for the price to sell and buy. Sellers will want maximum possible high price while buyers will be looking maximum possible lowest price for the goods and services. Welcome to the markets.
Depending on the economic climate supply and demand curves can move or shift either way, thus altering price and quantity structure.
The above is absolute basics of Supply and Demand in open markets. My intention is to utilize them on ways to apply Supply and Demand in trading rather than detailed study of Supply and Demand itself.
What is Supply and Demand trading?
Trading in financial instruments, whether it's Forex, Futures or Equities takes place in markets. We already know that for markets to function it needs sellers and buyers. Supply and Demand is all about spotting where buyers and sellers are sitting on our trading charts. However, we as a retail traders do not have access to current order flow. We cannot spot them within their current position. All we can do is looking back [left of our charts] to history and define previous Supply and Demand zones with the expectation that in those zones will still exist some serious buyers and sellers. Using lagging Supply and Demand information, we are making our trading decision based on historical data, not the current definitive data. We also know that what has happened in the past will not necessarily repeat at present time. We have probabilities to deal with. We use price action chart and candle patterns to improve probabilities in our favor.
There is one important difference between classic Supply and Demand theory and Supply and Demand that applies to traders. While on classic approach suppliers generally stays as suppliers in the process of exchange, however in trading we can not identify certain participants as sellers or buyers. All participants in trading can be buyers or sellers at any one time, even at the same time. Remember, trading means buying and selling. Buyers doesn't turn into sellers and vise verse. They already are both. When applying Supply and Demand in trading keep this in mind.
Foreign-exchange market has many participants in various class and size.
As we can see from the above graph Banksters are firmly in control of Forex. In spite of healthy growth of retailers market share, banksters will remain in control. Even if market share of retailers hit similar levels of banksters, they will still be in control.
a. Banksters generally acts in sync like one big cartel
b. Many funds and insurance companies are extensions of banksters
c. Retailers are extremely fractured and can not act in sync.
According to the graph above, retailers represent 18% of $4 trillion a day forex market as of 2011. That represents hundreds of billions of dollars up for grab on daily basis. Unfortunately, it's mainly grabbed by banksters.
Our task here clearly is to spot banksters and follow them. Forget about novice trader talk. We don't care who is on the other side of our trade as long as we are at the winning side. I have seen many non-novice so called pro traders and institutions loosing large sums to markets. We don't care about losers, our task is to identify winners and follow them. Remember, we do not anticipate but with guidance of the price we try to participate. That's all. Nothing more, nothing less.
How to identify and draw Supply and Demand zones on a trading chart?
Well, you don't have to. There is an freely available indicator does it for you automatically. Instead of spending time on drawing and updating your zones manually, it may be more beneficial for your trading to watch PA and check out historical price levels.
For those, who like to understand how zones are defined on a trading chart lets try to demystify it.
There are three types of price moves in markets.
1. Going up
2. Going down
3. Going sideways or nowhere [ranging]
There are some fancy terms circulating around to keep you busy for the purpose of expanding learning process for paid mentoring services or some who likes to keep their website busy with useless stuff. My advise is to keep clear of such complications as they are not aimed to improve your trading. Unfortunately many new traders would be get caught in these useless jargons and end up wasting their time.
What the heck are all these DBD-RBR-DBR-RBD?
Apparently they stand for:
DBD means Drop Base Drop
RBR means Rally Base Rally
DBR means Drop Base Rally
RBD means Rally Base Drop
Price drops and rise with flags, pennants and various chart - candlestick patterns or without out them. That's it. Why make things complicated? Keep in mind complicated things bound fail sooner or later.
Here we have a chart without any markings other than ask and bid price lines. Where are supply and demand zones?
Supply and Demand zones indicates price turning areas, where price reaches a point that balance will change in favor of other participants. It's the tipping point where imbalance between buyers and sellers is at peak. When imbalance is at its peak, change in direction is bound to follow.
For instance, when balance is on buyers' side we see price is going up. Simply, there are more buyers then sellers at those prices. However, once the price reaches to certain levels, participants start thinking price become too expensive, they start selling at new highs to maximize their profit. Additionally, certain participants would have exhausted their resources during their buying activity and there will be certain participants waiting on certain levels to sell too, which helps to cement a decent supply zone. Now, we have new sellers entering to the market plus some of those buyers closing their buys and joining in as sellers. Price will be travelling down until it finds the demand [where buying interests supersede selling ones].
So, supply and demand zones don't represent magical decision points as some may be stating, but rather zones representing imbalance at its peak. You can pour so much of water into a glass.
Just like in classical supply and demand theory. Suppliers can increase their prices so much, perhaps until there is not enough people willing to buy their products or services at those prices. Unless the supplier is a bone headed with a gigantic ego then he has to reduce his prices to get buyers interested once again.
However, we also know that heavy manipulation is going on in markets. We simply couldn't say natural laws of supply and demand. Remember fake-outs!
Lets use good old zigzag indicator as a visual helper to see peeks and drops clearly rather than polluting our heads with DBD-RBR-DBR-RBD stuff.
With the help of zigzag indicator we can identify major and minor price turning zones including older ones with ease. Now lets add supply and demand zones to the chart ignoring minor/weak zones.
Notice where zones are drawn in relation to zigzag highs and lows. It's not a big deal to recognize possible supply and demand zones, is it? I used default settings of the zigzag indicator.
It's fine looking at history and talking on hindsight but how do we know current higher high [hh] is the actual hh?
How to draw zones?
There may be different approaches on this but I like how supply and demand indicator draws them.
The key point to watch when drawing a supply or demand zone are HH [higher high] or LL[lower low] as they are starting points of a zone.
1. Bull candle at opening starts printing a bear candle [wick] then retraces making new HH. We take HH and the opening point of the bull candle draw the supply zone as shown on the chart 5. Before drawing the zone at least we have to wait for the close of following candle. Without it we wouldn't know our HH is HH as next candle easily can make new HH.
2. In situation like this, where LL is made by an engulfing candle we start drawing our demand zone from LL [which is bull engulf candle] to close of previous bear candle instead of close of bull engulf candle. Unlike most other zones with cases like this we use two candles to draw a zone instead of one. Similar situation applies when drawing a supply zone with HH engulfing bear candle. We take HH of the bear engulf candle and opening of the previous candle [please see 2b]
3. We see a usual one candle demand zone drawn. However, if you are using supply and demand indicator you will not see the demand zone printed until after candle c closed. Zone is not valid until a candle closed and not touching to zone. So it's always better to wait for confirmation before drawing a zone.
How to trade supply and demand zones?
Conventional recommendation is that we wait for price to come back to the zone [preferably untested fresh zone] to take a trade.
1. Enter when price deep in the zone with a small stop-loss.
2. Wait for PA confirmation then enter with bigger stop-loss.
Obviously on hindsight entry 1 would have been the best one but on live charts at this point we don't know if price is going to be contained in the zone or not. We could simply take the trade and hope for the best or look for something to indicate possibilities of price turning, zone holding. In my case first thing I see is signs of RSI divergence, and that would most likely be enough for me to take the trade [entry 1] as the risk is minimal, rather than delving into deep chart analysis.
On the other hand when we check left we don't have clean clear arrival, zone has been tested before twice which means it's not a fresh zone. Are there still decent buyers? Some negative vibes against taking trade. If we add a horizontal in the zone and check farther left we see some positive history.
If we opted for entry type 2, which says wait for PA confirmation once the price hits the zone, then we get two opportunities of entries on this occasion as highlighted on the chart 6 above. Notice, stop-loss size of entry 2a and 2b is bigger than entry 1.
In my trading, I use additional S&D zone entry in addition to above entries. I tend to take trades as or when a new zone established too. Sometimes before zone in sight. I will not go in details for this type of entries as it involves a few things to be taken into account such as reading left PA, spotting viable historical price lines and the way a new zone is created. This type of entries [some calls it "ahead of time trading"] requires a lot of experience and ability to keep in sync with overall market sentiment. Needless to say it's more riskier than conventional entries.
How do we workout PA Config [Price action confirmation] in supply and demand zones?
This is where chart and candlestick patterns come in. Remember, we use PA reading in and around the zones to try to determine if the zone will hold or not. I already have written few articles about PA patterns and their use in "Introduction to Price Action" AG forum category and under Education menu "Candle n Chart Patterns". I need to add few more PA patterns yet but what is available so far is more than enough to make a good start. You don't need to learn all PA patterns to be profitable trader. Important ones are more than enough in my opinion. I have started with important ones and most are done. I would recommend you to check them out so that you can fill the PA confirmation puzzle piece in place within the concept of S&D trading.
What time frames are best for supply and demand zones?
Supply and demand zones are applicable to any timeframes, in other words supply and demand zones can be drawn and traded on any timeframes. Only thing to keep in mind, supply and demand zones in lower timeframes can be taken out more often and easily than higher time frames. Seasoned S&D traders tend to trade in the direction of higher time frame zones.
What does this mean?
For instance, we have price just tested H4 supply zone, zone is holding and price started to move away [down] the zone. In this situation if we are trading on say M5 we'd be looking to sell on decent supply zones of M5 rather than buying at demand zones. Is this means we shouldn't enter any buy orders in such circumstances? Of course not. You can always benefit from decent M5 demand zones too as price rarely moves in one straight line but using supply gives us additional probability in our favor. There are no need to be greedy. We cannot get all the pips. That's until price comes close to possible reaction levels or closing on H4 demand zone. Regardless your trading chart time frame, it's always wise to keep an eye on higher timeframes.
Why some zones doesn't hold?
If I knew the answer to this question, I'd say I have the ultimate crystal ball. I could trade with zero losses. Unfortunately, I don't possess such crystal ball. All we can do is check the history, especially historical price lines to see possibilities for the zone may to be taken out or not. The only place to look for possible hints is left of your trading chart. Also keep in mind, during major events such as NFP, ECB press conference, FOMC minutes etc... most zones may be taken out easily.
I may comeback and expand this article further as and when needed.
Ken - Ace Gazette
ps/. You may download SupDem and plus other indicators here:
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