What Are Supply and Demand Zones?

If you ever took an intro to economics class in school, you must be aware that the law of supply and demand governs the market and how we operate. The law of supply and demand ends up ruling more things than you would otherwise think. In fact, these laws govern everything from your local farmer’s market to the trading market, to clothing, and even relationships. So what are supply and demand zones in trading, and what do they mean?

Supply And Demand Zones Defined

Supply and Demand Zones

In the trading world, supply and demand zones are commonly used evaluation metrics. They’re increasingly popular in day trading.

A supply zone replicates the situation where there is an excessive supply, so an area of supply would be a zone where a large number of traders are holding stock, and these investors are also willing to sell them as well.

A demand zone is again a similar example, an area of demand is a price zone where many traders and investors want to buy a market when the price gets better.

If an area of demand for a product is at a lower price level, that creates support; this can be an old area of a low price, an overbought reading on a chart, or a critical moving average.

A supply zone comes into formation before a downtrend, whereas a demand zone forms after an uptrend. Traders can customize their charts to identify demand and supply zones.

What Is A Support Zone?

A support zone is an area of interest where traders and investors are making transactions. For example, when a stock is overpriced and overbought, supply and resistance zones can work together to create an opportunity for buyers to exit at any possible chance. Which is what makes supply and demand zones good for trading.

How Does The Supply Zone Work?

When you’re learning about supply and demand zones, you want to know what supply zones are. The supply zone is essentially an area above the current price, and it’s also an area that holds a strong selling interest. Therefore, when the price reaches the stated level, the orders are filled out, and the price decreases.

Most stock prices rally up for a short while, pause for a little bit and then drop down because the price increase was artificially induced. If there are orders placed for the stock at a lower price, the price will rise again. As long as unfulfilled orders are waiting on the back end, the stock price will keep rising back to the supply zone.

The demand zone is where all the big buyers are located; the candlesticks or bars that mark the place of a strong downtrend are known as the demand zones.

How To Draw Supply And Demand Zones?

Supply and Demand Zones
Daily S/D zones on $SOFI

The best way to identify supply and demand zones is to consider a historical eye. First, look at the historical chart of the stock and try to place large successive candles.

Once you have evaluated this, you can establish the base from which the price started the move upwards/downwards.

It is essential to make use of appropriate charts when altering between multiple time frames. You can also draw a rectangular shape to denote this zone.

As a trader, you can also incorporate daily or weekly pivot points that can help you identify and confirm supply and demand zones.

A base must have a set structure where the candles should not be more than ten, and the candle body needs to be less than or equal to 50% of the candle range. The price also must have left the base with three extended range candles.

The best zones are the ones that have not been retested, i.e., the price has not reached that range ever since the breakout. The likelihood of a supply zone failing is higher if the stock movement has repeated itself more than once.

Gaps are also one of the best ways through which you can identify supply and demand zones. A gap is where the price rises or falls from the previous candle close without any trading happening in between. They also represent enormous supply and demand imbalances and are often accompanied by major economic news or events which create this market conditions.

Types Of Supply And Demand Patterns

Reversal Patterns

These reversal patterns are ones where chart patterns are formed when the trend reverses from up to down and from down to up. These patterns have a higher success rate as compared to continuation patterns. What patterns should we look for in supply and demand zones?

a)   Drop base rally

Price moves in a downtrend, creating a price drop; this is followed by the price reaching its base, after which it rallies upwards. These reversal patterns are strong.

b)   Rally base drop

Like the name, this process is the exact opposite. The price initially rallies upwards and creates a base structure, after which the price takes a drop back to its original position.

Continuation Patterns

c)    Drop base drop

Like the name, price drops at first, creates a base, then continues dropping.

d)   Rally base rally

Price rallies up and forms a base structure, after which it continues moving upwards.

Continuation patterns are generally weak in nature and are an exhibit of market volatility. However, market forces like economic events or news can break through them after a certain point causing them to stabilize.

Supply And Demand Trading Strategies

$NFLX Daily Supply and Demand Zones with RSI on lower.

Range Trading

Many investors commonly use supply and demand zones to engage in range trading. In addition, traders can make use of stochastic indicators or RSI to assist in identifying overbought or oversold conditions.

Range trading is also a non-directional form of trading where both long and short entries can be spotted. Traders can use the long-term chart to spot ideal entry points.

For example, range traders selling above the supply zone can set up stops at the supply zone and targets at the demand zone.

Breakout Strategy

Breakout strategies are another supply and demand trading strategy where prices cannot remain in a defined range and eventually move direction. Most traders look for ways through which they can gain favorable entry to the market.

Traders placing in short positions at the breakout are at risk of loss, and one way they can secure themselves is by anticipating the retracement back into the demand zone before passing the short trade.

The Bottom Line

If you’ve ever been in our Futures Trading Discord, then you know Rose is a big proponent of supply and demand zones. They’re a great way to trade, whether that’s futures or the S&P 500.

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