Trading Fundamentals for Supply & Demand Zones

The financial markets are a complete mystery right? Wrong, in our opinion. In this article we will give our perspective on the financial markets and attempt to bring an understanding to the movement of price through Supply and Demand Zones Theory. This information should be used for informational/educational purposes only and it should always be understood; there is an extreme risk in trading and risk capital can be lost entirely.

First we must look at the market's underlying source which is pure psychology. Each individual, commercial or institutional trader around the world make up this psychology and are force fed massive amounts of news to influence their thoughts. Media is the main source of news and can be rather manipulating to many if the information is not interpreted in the correct sense. Luckily for us there is a single piece of information that we all have which cannot be manipulated, price action. It is our job to interpret the data and analyze accordingly. Price tells us every action and reaction that has occurred for any given instrument therefore telling us what the majority of traders were thinking at that time and placing a historical value on that instrument. It also leaves foot prints along the way to indicate where price may pause, bounce or reverse at a future date. This leads us to our zone trading methodology.

Supply and Demand Forex, Futures, Stocks

Order flow analysis helps to see where upcoming potential market turns may take place. Order flow is a term used to represent the supply and demand of any given instrument. Supply and Demand is an economic model of price determination in a market. It concludes that in a competitive market, price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of both price and quantity. When supply exceeds demand there is a turn in price action. Price is driven down due to the quantity of goods being produced and the lack of demand for those particular goods. When demand exceeds supply there is a turn in price action. Price is driven up due to the quantity of goods being demanded and the lack of supply for those particular goods. To simplify the terminology supply refers to sell orders while demand refers to buy orders. It is important to note that a transaction must consist of both a buyer and a seller to exist. Whoever has the most orders wins. The equation is as follows:

Equation of a Supply and Demand Imbalance

Who are these buyers and sellers? There are three types that make up the financial markets:

1. Retail - Individual traders (home gamers)
2. Commercial - Corporate Entities ( pension fund managers)
3. Institutional - Banks / Investment firms

Retail traders hold very little influence on the financial markets due to a lack of liquidity. Commercial traders tend to have more liquidity however they are not as aggressive and do not attempt to change the financial markets, instead they typically follow them. This leaves the institutions, they are the most influential of all and usually cause the large reactions of price movement. It is our firm belief that you should be able to locate the institutional buying and selling on a price chart and make it a part of any trading strategy.

Large Imbalance buying and selling can be found in price action using four specific price patterns. Each pattern is comprised of three specific price movements and all of which are required. If any of the three movements are not completed there is simply not enough information to give an educated analysis. These price patterns have underlying psychology factors that are subject to change at any time and are indicated by pure price action. This is to say that each pattern has a different personality and every one will be unique from any other regardless if they are of the same "type".

Four Types of Price Action Patterns:

1. Peak - defined by an incline in price, followed by a pause and a decline

2. Valley - defined by a decline in price, followed by a pause and an incline

3. DBD - defined by a decline in price, followed by a pause and another decline

4. RBR - defined by an incline in price, followed by a pause and another incline

The above four patterns are simply a graphical representation of what has previously happened to the value of a particular instrument and offer the information we require to make educated decisions. Because they are all unique the trader must interpret the data at each pattern to determine if it is useable for an upcoming opportunity or if it should be filtered and left behind. While this may sound quite subjective, there is a very methodical approach that is applied. Price alone displays where the orders are potentially left standing and where the orders have been taken away. To help determine the usability of the pattern it is combined with other elements of price such as location and direction. The location of the pattern adds a perceived value of too expensive or inexpensive (cheap), while the direction displays what the most recent thought process has been which is known as a "trend". This helps filter out low probability setups and adds a sense of validity to others.

Determine Value

Using the combined analysis of institutional order flow, location and direction, price tells us when it is time to buy or sell with the perceived value. When the time comes to purchase or sell an investment it is also very important to know where. The above four price patterns allow us to define exact price points which an abundance of buying and selling has historically taken place and may take place again. This displays both time and location for the entry. Using mechanical methods a zone is drawn around a graphical representation of psychology (perceived value) primarily found on time, volume or tick based charts referred to as supply and demand zones for trading. Depending on the direction of price when the zone is formed, it will define whether the potential upcoming turn in price is to the buy side or sell side. The high and low of the zone are used to determine the exact entry point as well as the exact amount of risk involved. There are other aspects that should be taken into consideration before any form of execution takes place such as risk management and exit strategy. Just knowing when and where to enter into an investment is only half the battle.

One of the most common methods of risk management is a stop order. The distance from the entry to stop order defines the amount of risk one would lose if the trade does not go in favor. As mentioned above the high or low of a supply or demand zone will give the exact entry point while the opposing side of the zone will give the exact price point for exiting the position. The stop order may be placed at the top or bottom of the supply or demand zone. The method is as follows:

How to Place Entry | Stop Orders

Create a Strategy to Exit Each Trade

The last step to a potential trade setup is the exit strategy. When the investment is exited (closed) the broker now returns the instrument to the open market while disbursing the actual profit or loss into your account. The exit also comes from a supply and demand trading zone which is opposing to the entry zone. This means if the trading position was entered as a sell from a supply zone an opposing demand zone would be used to exit, if the trading position was entered as a buy from a demand zone an opposing supply zone would be used to exit. Due to the nature of order flow analysis price typically gravitates from one zone to the next therefore a mechanical approach is to enter at the level (supply and demand trading zone) and exit just before the next opposing zone.

Learn the Core Trading Strategy and Institutional Zone Theory