Trading 101: Trading Supply and Demand Zones
We have previously covered how to analyze price charts with support and resistance lines in our Trading 101 series. This time, we will take a closer look at a related subject called supply and demand zones. Let’s first start by defining the terms:
- Supply zone: An area on the chart where there are more sellers than buyers, aka resistance.
- Demand zone: An area on the chart where there are more buyers than sellers, aka support.
Similar to support and resistance lines, these zones are also often found in areas of the chart that can be explained with technical analysis, such as round numbers and Fibonacci levels, or price levels where fundamental forces previously have come into play. Market participants often remember these areas from earlier, and the power balance between the bulls and the bears in the market will shift.
Getting used to thinking in terms of areas or zones on the chart can be a very useful next step, once you have familiarized yourself with the basics of technical analysis. Support and resistance lines are wonderful concepts in theory, but the reality is that it oversimplifies how the markets really work.
Let’s take a look at an example of how traders end up losing money when focusing solely on one price level for their entries.
As you can see, the blue resistance line is drawn from a recent top in this market. However, when price again approaches the resistance line, it overshoots it and the retail traders who already entered their short positions will most likely get their stop-loss orders triggered.
Trading is not an exact science
Professional traders, on the other hand, know that trading is not an exact science and they instead draw these lines as zones or areas on their charts. That way, you can catch much more of the price action within this area of interest and you are able to wait for confirmation before entering your trade.
By waiting for the price to trade completely outside of these areas, as well as crossing for example the 20 Moving Average line, your trade idea has been confirmed by the market and you can now simply react to what is happening rather than trying to predict the next move.
From the chart above, we can see that it was easy to draw the supply zone based on the previous high in the market. When the price again enters into the supply zone, we can see a sudden shift in the direction of the trend. Smart traders know that they are entering an area with lots of trading activity, and act accordingly by tightening up their stop-loss, so that their sell order is executed at the first sign of a reversal in the trend.
Getting used to thinking in terms of areas on the charts instead of lines may be a bit more difficult for the beginning trader, because it requires a more subjective approach to trading which takes experience to master. However, once you do get comfortable with this way of thinking, chances are your trading performance will see immense progress.
Good luck with your trading and feel free to share with us any questions or comments.