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Lesson 5. Supply and demand
Supply and demand represent the fundamental forces driving all price movements in financial markets. While support and resistance identify key price levels where reversals tend to occur, supply and demand trading focuses on the underlying imbalances between buyers and sellers that create powerful market moves. Understanding these imbalances helps traders identify high-probability zones where institutional activity has previously shown significant interest.
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10 min read

In this lesson, we'll explore the concept of supply and demand zones, how they form, how to identify them, and how to incorporate them into your trading strategy. These concepts build directly on the support and resistance principles covered previously, adding another valuable dimension to your price action analysis.

What Is Supply and Demand Trading?

Supply and demand trading is a price action strategy that identifies zones where significant buying or selling activity has previously occurred. These zones often lead to predictable price reactions when revisited. While similar to horizontal support and resistance, supply and demand trading focuses specifically on imbalances between aggressive buyers and sellers.

This approach is based on the same economic principles that govern all markets. Just as product prices rise when demand exceeds available supply and fall when supply exceeds demand, financial asset prices move according to similar forces.

Illustration 1:

Market Orders vs. Limit Orders

To understand supply and demand mechanics in financial markets, it's essential to recognize that for every buyer, there must be a seller, and vice versa. Price movement isn't caused by having more buyers than sellers but by the aggressiveness of market participants.

This market dynamic is driven by two main order types:

Market Orders: Instructions to buy or sell immediately at the best available current price. These orders show aggressiveness and urgency to enter or exit a position.

Limit Orders: Instructions to buy or sell only at a specified price or better. These orders show patience and less urgency.

When aggressive buyers place market buy orders that absorb all available sell limit orders at current prices, sellers must raise their asking prices to attract trades. This drives the market higher. Conversely, when aggressive sellers place market sell orders that absorb all available buy limit orders, buyers must lower their bids, driving the market lower.

Consider a market trading at $100 with limit orders on both sides:

  • Sell limit orders: 5 at $101 and 10 at $102
  • Buy limit orders: 5 at $99 and 10 at $98

For price to move to $101, aggressive buyers must place market orders to purchase all 5 contracts at $101. To reach $102, they need to absorb another 10 contracts. When limit sellers see this buying pressure, they may pull their orders and set them higher, causing prices to climb further if aggressive buying continues. This order flow interaction creates the zones we identify as supply and demand.

How to Identify Supply and Demand Zones

Supply and demand zones are identified through specific price action patterns:

Demand Zones: Areas of consolidation before a strong upward move. These zones indicate where aggressive buyers overwhelmed sellers, creating significant buying pressure.

Supply Zones: Areas of consolidation before a strong downward move. These zones indicate where aggressive sellers overwhelmed buyers, creating significant selling pressure.

The strength of these zones is generally proportional to:

  1. The speed and magnitude of the move away from the zone
  2. The volume during the move (higher volume indicates stronger zone)
  3. The time frame on which the zone appears (higher time frames create stronger zones)

For example, a stock that consolidates between $45-$47 for several days before rapidly rising to $55 has likely established a strong demand zone between $45-$47. If price later returns to this zone, there's a high probability of another bullish reaction.

What Makes a Good Supply and Demand Zone

Not all supply and demand zones offer equal trading opportunities. The strongest zones typically share these characteristics:

  1. Formation on higher time frames: Zones identified on daily or weekly charts carry more significance than those on 5-minute charts.

  2. Strong, fast move away from the zone: The more aggressive the move away from the zone, the more likely it represents a significant institutional order.

  3. Fresh zones: Zones that haven't been tested multiple times maintain their strength. Each time a zone is tested, it weakens as orders are filled.

  4. Clean departure from the zone: Price should leave the zone decisively without returning immediately. This indicates a genuine imbalance rather than random price fluctuation.

  5. Time spent away from the zone: The longer price stays away before returning to the zone, the more significant the zone becomes.

  6. Clean approach back to the zone: Ideally, price should return to the zone in a controlled manner rather than with the same momentum that created the zone.

Key Takeaways

  • Supply and demand trading identifies zones where significant institutional activity has created price imbalances
  • These zones form during consolidation periods before strong directional moves
  • Higher time frame zones carry more significance than lower time frame ones
  • The strength of the move away from a zone indicates its potential importance
  • Fresh, untested zones typically provide better trading opportunities

Next Steps

In our next lesson, we'll explore chart patterns – recognizable price formations that help traders identify continuation and reversal opportunities. These patterns build upon our understanding of trends, support/resistance, and supply/demand concepts to provide additional trading signals.