The Essential Guide Supply And Demand Trading
Over the past few years a new type of trading method has become widely popular with forex traders.
Supply and demand trading is a trading method where the idea is to find points in the market where the price has made a strong advance or decline and mark these areas as supply and demand zonesusing rectangles .
The point in which the price has made a strong advance is marked by the trader as a demand zone
A point where the market has made a sharp decline is marked as a supply zone
The main premise of supply and demand trading is when the market makes a sharp move up or down the large institutions i.e banks/hedge funds are not able to get their entire trade placed into the market, therefore they leave pending orders to buy or sell at the zone with the expectation the market will return to the zone and the rest of their trading position will be filled.
To a new trader who doesn’t really know much about supply and demand trading, the theory I’ve explained above sounds like it makes sense.
The problem is the theory above is completely wrong with the way the forex market actually works. 90% of supply and demand traders all trade supply and demand zones with the idea that large institutions place pending orders at these zones ready for when the market returns, this is wrong ! institutions never do anything like this and even if they did put orders at supply and demand zones when the market would hit these orders it wouldn’t move anywhere because pending orders cannot cause the market price to change, only market orders can.
To understand why this is we must talk about something called liquidity.
What Is Liquidity ?
Liquidity is the ability to buy or sell something without causing a large price change.
Whenever you see the market move is it due to a lack of liquidity in the market, not because there are more buyers than sellers as is commonly taught in trading literature.
When someone places a market order it removes liquidity from the market because the person who is placing the market order is essentially demanding that his trade is placed right now, his market order is then matched with someone who has pending order to sell placed in the market.
If the market order is bigger in size than the opposing pending order, what will happen is part of the market order will be filled but the rest will remain unfilled, so the market must move higher in order to seek out additional pending orders to fill whats remains of the market order.
What this essentially means is pending orders add liquidity to the market, because they are the orders in which market orders will be matched with.
We as retail traders do not trade at a size big enough to effect the market price, placing and exiting trades is something we never have to think about, for large institution’s however, getting in and out of trades can be a big problem.
Because the trades they place are so big one of the primary goals of a professional trader is get a trade placed into the market with as little impact on the market price as possible, this means finding places in the market where alot of liquidity exist.
Most of the time pockets of liquidity tend to be found at places where retail traders put their stops losses.
The reason why stop hunts are seen frequently in the forex market is down to professional traders placing big trades into the market, they purposely push the price into the location of the stops to unload large trades all at the same price without moving the market a significant distance.
You can actually trades these stop hunts, check my article“Using Oanda’s Order-Book To Trade Stop Hunts ” for a step by step guide to finding and trading them.
What I’m want to do now is go through the main rules on supply and demand trading and explain to you why they don’t make sense within the context of how the forex market actually works.
Why Would The Institutions Wait To Get Their Order Placed ?
Before we get into the rules themselves I thought I would shed some light on the idea that institutions wait for the market to return to supply and demand zones to get their pending orders placed.
It doesn’t make sense to me that a zone which is really old still contains orders to buy or sell within it. I mean, If there is a supply zone which is three years old and the market has not returned to it for the past three years does it really make sense the banks still have a pending order to sell placed at the zone ?
On top of this, how does the bank know what the market is going to do ?
There’s no way for them to know if the market is going to return to the zone or not so why would they place an order there in the first place ?
Time Spent Away From Zone
One of the primary rules supply and demand traders use to gauge whether a zone has a high probability of working out successfully is the amount of time the market has spent away from zone.
Apparently, according to many supply and demand teachers, the longer the market has been away from a supply or demand zone the better chance the market has of turning when it eventually returns.
This again is flawed thinking.
If the bank places a pending order to buy or sell for when the market returns to a supply or demand zone are they really going to wait a long time for this to happen ?
If we compare the old supply and demand zones (colored blue), with the more recent zones colored orange, its easy to see how trading zones which have been created recently is far more profitable than trading zones which were created a long time ago.
Lets Imagine you had traded the 6 recent zones I’ve marked on the chart, each zone would have resulted in you having a successful trade, however had you traded the older zones, only one of them would’ve turned out to be a profitable trade.
So really the example above proves to us the quicker the market returns to a supply or demand zone the better the chance it has of giving you a successful trade, older zone do not tend to work out very often, therefore its better if you only place trades in zone which have been created recently.
The Strength Of The Move Away
One of the fundamental rules to trading supply and demand is “The stronger the move away from a zone the higher the chance the market has of having a strong move away when it eventually returns”
In other words, if you mark a zone on your charts which has a strong move away from it, how likely that zone is to result in you having a successful trade depends on how big the move which created the zone was.
If you marked a supply zone which had a huge drop consisting of multiple bearish large range candles then according to the rules the zone has a really high chance of working out successfully if you decide to trade it.
Unfortunately the likelihood of a supply or demand zone giving you a successful trade has nothing to do with whether the move out of the zone was strong or not.
How many times have you placed a trade at a supply or demand zone which has a strong move away only to see the market fly straight through it when it returns ?
A large number of times I bet.
This is because the strength of the move away has nothing to do with how strong the area is.
Common supply and demand teachings would say this is a strong area, yet as you can see the market breaches it without even stopping ! Which brings me on to my next point…….
How To Determine Which Zones Are Stronger Than Others
Now we know a big move away from a supply and demand zone doesn’t have any effect on the likelihood of a trade working out profitably or not we need to answer the question “how do you determine which zones are stronger than others”?
The answer is where is the zone in relation to the trend.
Check out this demand zone on the daily chart of EUR/USD
Whoever brought when the market was down here has a lot of money at their disposal.
To know why requires an understanding of market psychology.
As a trending movement increases in length, more and more people begin trading in
the same direction. Look at the last drop you can see on the chart before the demand zone is created, at the time of this drop tens of thousands of traders are all beginning to go short expecting lower prices, in order for the market to be able to move up from here, someone needs to come into the market and buy from all the traders who are going short.
This would take a huge amount of money, probably hundreds if not billions of dollars.
The market eventually stops falling lower and begins advancing higher, creating the demand zone marked on the image. This zone has a very high probability of giving us a successful trade, not because it has a strong move away, but because we know whoever brought down here creating the zone has invested a lot of money into the market.
Why would someone spend all that money buying up all the sell orders from thousands of traders if their still expecting the market to move lower ?
This example was taken from the 1 hour chart of EUR/USD
Apart from the change of time frame the example above is a very similar to what we looked at previously. First we have a significant downtrend which many people can easily see with one look at the chart, then we have a strong, near vertical move up. This move up tells us somebody has come into the market and brought up all the sell orders from the traders going short into the downtrend.
Again why would someone come into the market and buy from all the traders going short if they were expecting the downtrend to continue ?
The supply and demand zones which have the highest probability of working out successfully are the ones found at trend reversals. A demand zone created after the market has been going down for a long duration of time has a much better chance of working out profitably than a demand zone which forms at the beginning of a down-move.
It’s the same for supply zones too.
In a situation where the market has been going up for a long time a supply zone which forms late into the lifespan of the move up has a far better chance of resulting in a successful trade than a zone which is created at the bottom of the move up.
Time Taken To Return To The Zone
There are two types of trading institutions participate in.
The first is intra-day trading, in which the aim is to capture many small market movements over the course of the trading day generating small amounts of profits in the process.
Bank traders who trade intra-day will want their trades placed during that day, none of them will hold their positions overnight, this means the market makers will have to work the price in the market to places where these intra-day traders will want to buy or sell.
The majority of theses places will be supply and demand zones.
So if we know these intra-day traders will not hold trades overnight then its likely that if the market doesn’t return to these zones within a 24 hour time-frame they have a much lower probability of working out.
Here’s a rule for supply and demand traders who primarily trade the 1 hour chart.
You should only trade zones which the market manages to return to in 24 hours.
If the market has failed to return to a supply or demand zone you have marked on your charts within 24 hours then the zone becomes invalidated, you don’t trade it again, it has no relevance anymore.
I’ve completed lots of test on this and found 24 hours is the max, anything over this and the probability of the zone decrease dramatically.
If your someone who happens to trade supply and demand zones on the daily chart, then the market must return to the zone within a month, if it hasn’t returned before the end of the month the level becomes invalidated and you must not attempt to trade it if the market returns.
The reason for this is due to the other type of trading banks participate in, long-term position trading.
These long-term positions the banks take is what causes trends to occur in the forex market.
The large institutions who operate in the forex market all collaborate together in which direction their planning to take the market and then manipulate the prices so it makes everyone think the market is going to go in the opposite direction to the way in which they are going to be placing their trades.
Here is an example I found on USD/JPY
First notice how there is a significant downtrend which by this point had been in place for nearly three years, due to the fact the market has been going down for such a long time it means the majority of the traders in the market are going short.
Then out of nowhere we get a sudden up move. This is significant because of how long this downtrend has been in place, many many people are selling USD/JPY due to this downtrend, for the market to suddenly move up means the banks have entered the market and brought huge positions off all the traders who have been selling.
What the banks do then is very clever, they let the price drop, this makes everyone think the downtrend is going to continue so they all start selling again. When the market returns to where the banks initially brought, they buy again, this second round of buying coupled with the mass liquidation of losing positions by the traders who were selling is what causes the market break significantly higher and begin trending.
When large institutions place trades in the market they will want all their trades to be entered at a relatively similar price range, they will not place one trade at one location and then wait until the market has moved far away from their first trade before placing the second one, this is why the market returns to the daily demand zone shown on the image.
As with most forex trading strategies supply and demand traders incorporate the concept of trend into their analysis of the market.
The problem is the way the traders implement the concept of trend.
Typically what a trader will do is go on the daily chart and see that overall the trend is down, therefore they are only going to take trades at supply zones as they have been told to always trade in the direction of the daily trend.
There is nothing wrong with this so long as the trader is taking trades off the daily chart.
If the trader is taking trades off a lower time-frame then problems can arise as they are always going to be trading against the trend on the time-frame they take trades off.
If for example the trader take trades off the 1 hour chart then they are unnecessarily going to lose on multiple trades because they believe they should be trading in the direction of the daily trend, regardless of whether the trend on the 1 hour chart is up.
People don’t realize, the trend on the time frame you place all your trades off is the one you should be following. If you trade the daily chart then you should be trading in the direction of the daily trend, if you trade the 1 hour chart you should be trading in the direction of the 1 hour trend.
For the most part a large percentage of the trading information you hear online is wrong, It doesn’t take a genius to figure out the facts if you spend a small amount of time analyzing the details. Pending orders cannot move the price of an exchange rate, the fact that supply and demand trading is primarily based off this assumption means either Sam Seiden doesn’t know much about trading forex or he purposely gives out incorrect information in order to get people to buy his trading courses.
If you begin trading supply and demand zones using the adjusted version of the rules laid out to you in this article I’m sure you will achieve a better success rate when trading the zones.
The links below are to all the other articles I have written about supply and demand trading found on this site.
A Simple Supply And Demand Indicator You Can Use On MT4
The Two Types Of Supply And Demand Zone
How To Easily Draw Supply And Demand Zones
How To Trade Supply And Demand With Price Action
Warning Signs Of A Supply And Demand Zone Failure
What Makes Supply And Demand Trading So Popular ?
Supply And Demand Zones Inside Breakout Zones
Second Entry Supply And Demand Zones
Finding True Supply And Demand Zones Using Oanda’s Order Book