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Supply & Demand Zones
Supply and demand are the driving forces behind all movement in the stock market. When demand exceeds supply, prices tend to increase. When supply exceeds demand, prices tend to decrease.
The supply and demand strategy identifies and charts these imbalances, giving us high probability zones where price is likely to reverse.
By using these zones, we are planning entries and exits where large buying and selling liquidity enters the market. This gives us an edge by avoiding the traditional retail traps that come with breakouts, lagging indicators, fake outs, and FOMO.
How do imbalance zones form?
When institutions want to place a large order, they are unable to place it all at once because it would drive the price too far away from where they want to get filled.
Instead, they place a large number of limit orders within a desired fill range. When these orders are placed, the supply and demand equation becomes imbalanced and the asset price will move quickly out of the zone, usually leaving many orders unfilled. This is how most institutional orders play out and it occurs on a daily basis on every timeframe.
With all of these orders left unfilled, we now have a supply or demand imbalance. Leftover buy orders = demand imbalance. Leftover sell orders = supply imbalance.
Next time the price returns to this zone, retail traders provide the liquidity for the leftover orders and the imbalance will cause the price to reverse.
If price rejects or reverses within a zone, it means many of the orders were filled and we now consider the zone “USED.”
Used zones hold less conviction than fresh zones, so position sizing and risk management should be adjusted accordingly.
If a price passes through a zone, this means that buyers/sellers overpowered the imbalance or there were simply not enough orders left over. When this happens, we invalidate the zone and delete it from our charts.
How do we identify and chart imbalances?
There are 4 patterns to look for when identifying supply and demand imbalances. Each of these consists of 3 candles:
Demand Imbalances:
- RBR (Rally, base, rally)
- DBR (Drop, base, rally)
Supply Imbalances:
- DBD (Drop, base, drop)
- RBD (Rally, base, drop)
There are 2 rules that MUST be present within these patterns for it to be a valid zone:
- The rally or drop candle that follows the basing candle has to be a very strong move.
- Basing candles in demand have to be red, and have to be green in supply.
Start on a weekly timeframe looking for these patterns, then move down through 1d, 4h, 3h, 2h, 90m, 1h, 30m, and 15m.
Often times you will find smaller timeframe zones within larger zones. Remember that zones are invalid if the price has since passed through the zone, so it is useful to chart from right to left looking for fresh imbalances.
When drawing demand zones, draw the zone from the opening of the basing candle to the end of the lower wick. When charting supply zones, draw the zone from the opening of the basing candle to the end of the upper wick. I like to use transparent green boxes for demand and red boxes for supply.
*Note that zones can also exist as ranges, order blocks, or wick-to-wick candles (not just open-to-wick candles). There is no one size fits all and different methods will be more or less effective in any given scenario. Backtest and experiment with drawing your zones using all the above methods to identify when and which are the best for you.*
It’s also helpful to label the zone with the relevant timeframe and whether it's a used or fresh zone.
IMPORTANT CONSIDERATIONS:
- When charting zones on equities, make sure to have extended hours turned off. Institutions do not usually place orders during extended hours and there is not enough liquidity to give us sufficient data to have conviction in any zones formed.
- When looking to trade SPY and QQQ, chart on /ES and /NQ, respectively, and have extended hours ON. These are the futures for SPY and QQQ and have sufficient liquidity in extended hours, which is important for us to see the zones that formed during the day AND overnight. You can trade contracts in SPY and QQQ while charting the futures.
Entering a trade
The most important part about entering trades within supply and demand zones is CONFIRMATION. It is never a good idea to enter a position only because a price has entered a zone. You want confirmation that the buyers are present within demand and sellers are present within supply. Try to aim for at least two confirmations when entering a trade. Here is a list of possible confirmations:
- Demand forming within demand, supply forming within supply
- Favorable volume increasing (strong buy/sell volume within demand/supply)
- Build up of liquidity (relatively equal lows/highs) just beyond supply & demand
- Breaking of price pattern within zone (wedge, flags, H&S, etc)
- Relative strength/weakness vs the overall market
- Bullish/bearish price action (higher lows, lower highs, etc)
- News catalyst
- Markets /ES or /NQ in complimentary zone
Exiting a trade
- Set a mental or actual stop-loss at the end of the zone off of which you are basing your trade.
- Target the nearest supply/demand zone or the next lower low/higher high consistent with current price structure.
- Base your exits on levels and rules, not dollar value gained or lost.
Avoid choppy markets & practice patience
If you are trading equities, keep an eye on the respective index and make sure it is complimenting the move you are anticipating. For example, you do not want to take TSLA long if /NQ is approaching or inside of supply. And you do not want to take AAPL short if /ES is approaching or inside of demand.
You also want to avoid “choppy” days when the markets are sticking to a tight range. This means that the market is balanced, participants are in agreement on prices, and there is not enough volatility to capture any big moves. We only want to trade in IMBALANCED markets.
If /ES or /NQ are choppy, it is best to avoid trading equities altogether. You may be able to find some setups, but the probability of big winners will be lowered due to lower volatility.
The worst thing you can do is force a trade out of boredom or necessity for profit. The most successful day traders take 0 trades on days when the market conditions are unfavorable. If you do find a setup on days like this, reduce your position size.
The ONLY exception to this rule is when a stock is showing relative strength. If the market is choppy but an equity is making strong moves and trending with volume, then valid setups can be taken.