The financial markets are a complete mystery right? Wrong. In this article I will give my perspective on the financial markets and attempt to bring an understanding to the movement of price through Supply and Demand Zone Theory. 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 upcoming opportunities may take place. This leads us to our zone trading methodology for supply and demand.
Order flow analysis gives a low risk ability to see where upcoming market turns will 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
2 buyers + 1 seller = more willing demand moves prices higher
2 sellers + 1 buyer = more willing supply moves prices lower
Who are these buyers and sellers? There are three types that make up the financial markets:
- Retail - Individual traders (home gamers)
- Commercial - Corporate Entities ( pension fund managers)
- 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 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 in order to be a successful trader.
Institutional 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 left standing and where the orders have been taken away. This simple yet effective data informs of the probability for a future reaction. 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 opportunities and adds a sense of validity to others.
Determine Value Before Investing
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 the major buying and selling has taken place and will likely 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 upcoming opportunity is a buy or sell. 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. Until a position is closed the profit margin is nothing more than paper and does not represent real money in your account therefore it is crucial to have an equal plan for managing a position including the exit strategy to capture your profit or loss.
The most common method of risk management is a stop order. The distance from the entry to stop order defines the amount of money one will lose if the trade does not go in your 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 to minimize any further loss. 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
Trading Supply Zone: low of the zone = entry price, high of the zone + 1 = maximum risk
Trading Demand Zone: high of the zone = entry price, low of the zone - 1 = maximum risk
Create a Strategy to Exit Each Trade
The last step to a potential trade setup is the profit potential exit strategy. This is where the paper money becomes real money. 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 simply gravitates from one zone to the next therefore the mechanical approach is to enter at the level (supply and demand trading zone) and exit just before the next opposing zone.
In conclusion, Analyzing/Trading supply and demand zones can be very rewarding and fun especially when pre determining when and where the markets will turn before they actually do. However while it may be fun it should be approached very methodically in order to truly follow the institutions. After all they are who control the market. I like to think of the institutions as a shark (absolutely no pun intended and this will make sense after the analogy). The shark swims around the ocean and is feared by most creatures so it is known that a shark has major influence on what occurs. A pilot fish follows the shark and eats the parasites off him, in return sharks do not eat pilot fish and protect them from other species. In our analogy we are the "pilot fish". As a retail trader it is most common to have less liquidity than most any institution as well as commercial trader which makes us the smallest of the species. The key is knowing and admitting to this which allows us protection and plenty of food to eat.
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