The law of supply and demand explains the variation in prices for any asset or a product in the world. Basically, it says that if many people want a product and the market cannot meet the demand, the price of that product increases to its equilibrium point.
The reverse is also true. When there is a surplus of a product in the market due to low demand, the price of this product decreases until it becomes attractive to buyers.
Suppose this happens with manufactured and tangible products with other factors such as labour, raw materials, transportation, etc., to impact the pricing. In the same way, this phenomenon will occur in the forex market, which is much more speculative and takes impact from several fundamental and technical factors.
How are supply and demand presented in forex?
The demand and supply are presented as a desire of investors to buy in volumes greater than those offered by the market at a given moment (in the case of demand) or sell more than the market is willing to buy (in the case of the supply).
This imbalance generates a sharp price movement, and then a small stabilization begins. This stabilization is generated by the entry of new players seeking to take advantage of the new price level. After the price consolidation, there is a turning point that changes the trend. As the case may be, the zone located above or below the change in trend is called the supply zone or demand zone.
The correct identification of these zones allows traders to decide when to enter and exit a certain position using the supply and demand zone as the basis of their strategy.
When are supply and demand zones formed?
Supply Zone: Although it's very similar to the resistance level, the supply zone is wider and represents the place in the chart where traders are selling huge amounts. In the supply zone, the desire to sell begins to be higher than the desire to buy, so the price increase slows down due to the supply, and finally, the reversal occurs.
Demand Zone: In the demand zone, the volume of buying begins to exceed the selling volume. Here the price falls to a level where it becomes interesting for buyers, and this interest increases the price causing an uptrend.
Supply and demand zones and the time frames
The foreign currency market is very volatile, and everything happens very fast. The supply may be higher in one minute, and the demand may exceed it the next. This is why the time factor is the key. To use a strategy linked to demand and supply, these areas must be linked to a time frame.
For instance, let's take a look at the chart above. There, a supply zone is established using a short time frame. During this time frame, the price is always below the supply zone, which makes us think that the construction of this supply zone is correct and a good guide to drawing up our strategy.
But if we see how the price behaves over time, we see that the value rises just a few minutes later. This means that for a supply zone created for a short time frame, the expected price behaviour is too valid for a short time frame. Thus, strategies based on supply and demand zones can be used with all types of time frames, although the longer the time frame, the better.
How to find supply and demand zones?
To find supply and demand zones, it is necessary to find areas where the price has moved rapidly. This indicates an imbalance between supply and demand, between the selling volume and the buying volume. Then the price will have a lateral consolidation movement to finally reverse the previous trend.
The base of the supply zone will be at the top of the last candle belonging to the strong upward trend.
The base of the demand zone will be at the bottom of the last candle belonging to the strong downward trend.
The height of the price consolidation candles gives us the width of the zones for both cases. It is common for the tail of the candles to enter the supply and demand zones.
What makes a supply or demand zone a good one?
The fact that you can draw a supply or demand zone doesn't make it a good one. This is why here are some tips for finding a good zone:
- A good supply or demand zone is narrow. A strong movement within the area that we have selected can prevent large investors from reacting when the price returns to our area, which prevents the price from rebounding since the actions of those large investors are what modifies the trend.
- We want the price to stay in the zone for a short time. For example, only a few candles should be within the zone. If this does not happen, large investors are not reacting at that point which prevents the price from moving in the direction we want.
- Sometimes a breakout occurs in the opposite direction of which we want. This causes amateur traders to get scared and abandon their strategy. Unfortunately, there is no way to know exactly when a breakout is false or real. That's why it is said that strategies based on supply and demand zones are more art than science and that practice makes perfect. So, based on studies and experience, each trader must decide what his strategy will be.
- When you find a supply or demand zone, you want to avoid the price getting into that zone many times because when this happens. The possibilities of a trend change are reduced since the large investors in the market begin to see this value at a stable level, thus reducing the incentives to buy or sell quickly.
- Finally, what you want to see to define a supply or demand zone is a turning point in the price trend. If, after a rapid fall in prices followed by a short period of consolidation, there is an upward trend reversal, we have a possible demand zone. On the contrary, after a rapid rise in price levels, we have a small consolidation period consisting of a few candles and a downward trend reversal, possibly a supply zone.
The principles of supply and demand are supported by empirical evidence throughout the economy and have proven their validity for centuries. However, a strategy based on the supply and demand zones is not exactly mechanical and depends largely on the traders' experience. Additionally, the validity of any zone that each trader can find varies according to different criteria to consider but mainly depends on the time frame.