This article will explain some useful factors to consider when trading based on the supply and demand methodology. I will provide a brief overview of supply and demand before delving into how to identify high probability levels from which to trade.
Supply and Demand Overview
The only reason why price moves in any and all markets is because of an imbalance in supply and demand. The greater the imbalance, the greater the move.
Strong moves in price away from a level indicate that not all orders were filled. For example, at the origin of a supply level, there are not enough buy orders to fulfil the number of sell orders. This is why price moves away in such a strong fashion. When price returns to those levels, the novice traders are buying into an area where institutions have their sell orders. Institutions and professionals sell to the novices then there are no more buy orders so price must fall again. The opposite is true for demand levels. In both cases, the novice traders provide the liquidity the institutions need to get their orders out in the market.
The best opportunities to profit in trading are where we can buy at the cheapest price possible (wholesale prices) and sell and the most expensive price possible (retail prices). This is the same in any market. Supply and demand levels on a price chart show these wholesale and retail prices.
If you pull up a price chart you will generally see a multitude of supply and demand levels on every timeframe. By no means are we interested in trading from each and every one. Supply and demand levels are not all created equal. Certain levels are more likely to hold than others.
Some common factors to consider when choosing levels to trade from are listed below:
- Strength of the move - The way in which price left the level. Ideally quickly with large candles
- Risk/Reward - A decent risk/reward ratio will help to ensure you remain profitable in the long term despite your inevitable losses from time to time
- The big picture - The higher time frame trend or bias will help keep you trading in the right direction
- Retracements - Is the level fresh or has it been tested. Fresh levels are best
- Time at the level - The less time the better as this indicates a greater supply and demand imbalance
- Arrival - No opposing levels nearby for a smooth ride to the target/s
The factors above are some of the main factors that should be taken into account when deciding on which levels to trade from. Personally I go beyond that to fine tune the level picking process to increase the odds even further.
I like to mark up “key levels” on my charts. These levels are important to me; not in the sense that I would trade from them, but because others have traded from them in the past and I like to see how price reacts at these levels. Some people might call them pivot points (PP) support and resistance (SR) or decision points (DP) but for the purposes of this article I will refer to them as key levels.
A key level is one where the chart has shown price action which draws my attention. This could be a point from which a drop or rally occurred but not supply or demand level, or a level of conventional support or resistance.
When I see one or more of these levels broken, I go and look for the source of the move that broke the level. This will often point to a supply or demand level and provided all the other criteria are met, I have a setup with increased odds of success. The reason this is important is due to the fact that traders tend to react at key levels. When they are overwhelmed by an opposing force, you have a better idea of where smart money is moving the market. Below are some examples of key levels being broken by supply and demand.
GU H4 Chart
As you can see from the image above, the prior low was taken out and the origin of the move shows a big supply and demand imbalance indicated by the huge red candle. There is nothing but green candles going into the level so no opposing levels nearby until below 2:1 target. The modified fib tool shows that the original move was more than 3 times the size of the level so the risk to reward looks good.
EU H4 Chart
Once again the prior low was taken out. The origin of the move that broke the key level is highlighted by the supply level. Clear green candles into supply show profit potential coming into the level and no resistance to stop price falling. There is no demand below so price is free to fall to the next key level. The fib tool shows the risk to reward on the trade.
I approach the process of choosing levels in one of two ways; I either see the supply or demand level then look to see if it broke any key levels, or I’ll identify a broken key level and work back to find the source of the move that caused the break. Both approaches work fine. The main point is to find out if a level was broken or not to increase your odds for the trade.
When supply and demand levels are broken
If I have a short bias and a demand level has just been absorbed or broken, I will take shorts from a supply level with increased confidence now that an opposing level has just been taken out. Conversely, if I have a long bias and a supply level has just been absorbed I will now be more confident in buying from a demand level.
I want to see a clear path to profit before I enter a trade and when an opposing level is absorbed or taken out, I have more confidence for the trade. Please see the screenshots below for examples:
EU 30m Chart
The supply level is absorbed and there is a fresh demand level just below. Price is now free to move higher will little resistance until the next major level. The risk reward looked good so I took this trade. This is on a 30 minute chart and this demand level formed from a daily demand level. Multiple time frame analysis is beyond the scope of this article but I will write another one to explain how that works with choosing the right levels.
EU 5m Chart
In the picture above we see that a demand level was taken out along with two key levels. When we look up to what might have caused the move and we see a nice looking supply level with big candles leaving the level. This was another nice trade.
These are a few examples of how you can improve your success when trading supply and demand by choosing the levels which offer and increased chance of success.