How to Draw Supply and Demand Zones
Hello traders, welcome to the Price Action Course and the first module introduction to price action trading. In this lesson I’m going to talk about supply and demand zones. I’m going to explain to you what supply and demand are and why it is important for a price action trader to understand and learn how to draw these zones.
Let’s start by defining what supply and demand are. And to do this we have to remind you of the only reason price moves in this market and the only reason price moves is because of an imbalance in supply and demand. This means that when you have an imbalance of buyers and sellers, price will move, and the larger the difference, the stronger the move will be. For example, if you have more buyers than sellers in a market, price will start to go up, and on the contrary if you have more sellers than buyers in the market sellers are going to be taking out on those buyers and price will go down. This is the basic information that you need to know about supply and demand. And of course if you were a trader you already know that this imbalance is what makes price move and the higher or the larger the gap between these two forces, the stronger the move will be.
Now, supply is the level at which someone is willing to sell an asset. Someone is willing to supply it into the market for someone to buy it. So when supply is strong enough, a resistant level is created. Demand is a level at which someone is willing to buy something. When demand is strong enough a support level is created. And of course, demand and supply are the forces behind what support and resistance is. But support and resistance are not enough of information to be trading those levels. So you need to understand and you need to know what supply and demand are. And of course we will also teach you how to draw these levels.
The reason is that, let’s say the price is coming down to a very strong demand level and you know that it is very strong demand level because you already know how to read candlesticks. Let’s say that you’ve had a couple of tests of this demand level where buyers tried to break below it but the buying pressure was so strong that the buyers were unable to close below it. So you already know that this is a very strong demand level. Let’s say at the fourth test of this level, the demand level breaks. Because you’ve already established that this is a super strong demand level, you will know that by looking at the break out candle, you will have a very strong break out so you are going to be trading the short side of the demand level because of the market structure that we just discussed.
It is important for you to understand what a supply and demand zone is and how to identify a strong or not so strong supply and demand zone. Of course you also need to know that the higher we go on time frames, the stronger the zone is. But let’s continue, understanding what supply and demand zones are will give you an edge on your trading. Trading supply and demand zones may be the simplest of styles. But waiting for price to reach these zones will give you a better risk to reward ratio on a much higher probability trade, meaning that because you already know these are very conflicting zones you are going to know what to do when price gets there. Because you already know how to read candlesticks, you will know if you’re going to take the short side or the long side of these levels.
Now, supply and demand zones are created on any timeframe but the higher we go the stronger the zones are just because the higher we go the longer candlestick take to complete or to close. Now price action traders pay close attention to these areas for bounces and breakouts whether they have a position on or they are just waiting to enter the market. Now, let’s say that you are already [inaudible 00:04:56] U.S. dollar and prices reaching at a strong demand zone. Because you are a price action trader, you are not going to close this position just based on a demand zone. You are going to wait for a reaction to this level and if you already have a position on price balances but you are on a very strong down move, you might go along just to hedge with your position and wait for the break out. But if a break out happens, you can add to your position if the candlestick shows you that this breakout is actually a strong one. So, everything is coming together and you will see that once we go to the charts, it’ll make much more sense.
Now, how to draw supply and demand levels, and every supply and demand is not just a single line but an entire zone where previous bases have formed. The best way to draw this zone is with a rectangle. We need to look for previous highs and lows where bases were formed and rejections happened. Then we draw rectangles from the high and lows of these bases to form supply and demand zones. When these zones are marked on the charts, we wait for price to reach them and using the information behind candlesticks, we look for bounce straights or breakouts. Now we’re going to go to the charts and we are going to draw some levels on the Euro-U.S. dollar.
So here’s the Euro-U.S. dollar 60-minute charts and as you can see we are in a very strong down move. Right here, we have reached a very strong demand zone. Okay? Now, what we’re going to do is we are going to look for a base. You can see that here we have the first rejection at a round number, the 1.1800. Now, what we’re going to do is we are going to use that rectangle and we are going to draw the first part of the rectangle right here at this level. Then, we’re going to look for the next low. And the next low is this spike low right here at the rejection of the 1760 level and once we get this, we draw the rectangle and we just follow the chart to have the level. Okay?
Now, we already have this demand level but you can see that right here we have a supply level. Now what we’re going to do is we’re going to grab the rectangle once again and we are going to grab the low of this move and the high of this move to draw a new rectangle. This rectangle, of course, is a supply zone. Now, let me just follow the chart like we did with the last rectangle and you can see that we do have right here a very strong supply zone and right now price is between this demand zone and this supply zone and you can see that when we drew it, price bounced off of it and it bounced off of it again. If we were actually trading this zone, we could be trading the bounces up and down but what I would do is just wait for a much better spot when price breaks above. Maybe when price breaks above, we test this area and then close to the upside, but of course this can also be a better flight of the entire move down which means that price might just rebound from this supply zone and break through this demand zone moving lower to the 1500.
Now let’s go back in the charts and let’s draw some levels, maybe on the weekly timeframe for you to know what can you expect. If you see right here, we do have the two rectangles that we drew on the hourly, but you can see that on the weekly, we do have a very strong level. And the level we are going to draw is the level starting with this low and going to this high right here. As you can see, we have broken below this level on the weekly chart. Okay? Now let’s thicken our chart a little bit so we can better see the candlesticks. And as you can see, we have broken with this demand zone on the weekly, which is a very strong demand zone because you can see that we tested it here once and we tested it here twice. I only have 365 days worth of data here and I could go and look for a couple of years back, but because this is just an example of a very strong demand level, we’re going to work with it. We tested it once, we tested it twice, the demand level for and right here you can see that we have broken below and we can start to look for shorts when we break out of the demand zone that we drew on the 60-minute chart for a short to the 1600 level.
This is basically how you draw demand and supply levels on your charts and if you want the example again, you can see that it works very well, for instance, on this demand level right here – price broke and it moved quickly 1000 pip to the down side and if you want to continue to draw strong levels on this chart, you can do so by doing this with this low and this base right here. And you can see that this is something of a self fulfilling prophecy because we’re using the low of a move, which is this low right here and then we’re using the bases that are formed afterwards. And you can see that here we tested it once, twice, three times after this low and when we broke to the downside price, re-tested the same demand level as resistance before moving down.
So, basically this is how you draw them and how we’re going to use them further on in this course.