An Introduction to How to Trade Supply and Demand Zones in Forex?

An Introduction to How to Trade Supply and Demand Zones in Forex?

Reading time: 7 minutes

If demand exceeds supply for a good or service, the price tends to increase (ceteris paribus). Conversely, if supply outstrips demand, the price of that good or service typically falls. Fortunately, for traders who employ technical analysis in the Forex market, or any tradeable financial market, you can apply supply and demand areas to a chart to help identify clear and actionable trading zones.

However, beginner traders often confuse support and resistance with supply and demand. Although they serve as floors and ceilings on a price chart, how they are applied varies. A support and resistance level (or area) often cuts through price, while a supply or demand zone is applied to recent price action and is generally only traded at the first test of the zone.

Supply and Demand Zones: How Are They Structured?

There are four main structures of supply and demand, all of which are widely used by traders in the Forex market across various timeframes.

A rally-base-rally zone is a form of demand and is established within a defined uptrend – consecutive higher highs and higher lows – or at the beginning of a possible move higher. This price movement begins with a rally, moves into a base, and subsequently follows up with a follow-through move higher. Just be mindful that this is a continuation configuration. A drop-base-drop zone is the same as a rally-base-rally area, only the mirror opposite. Therefore, it serves as a supply form and is a continuation zone to the downside within downtrends.

A drop-base-rally zone usually forms what’s known as a bottom on a chart, or sometimes referred to as a cap. Its basic configuration is lower lows and highs forming a downtrend, which then transitions to a base form. The declining market structure represents the drop and the consolidation forms the base. A reversal follows to the upside, creating the zone, which is tradable upon return. This is typically a zone in which buyers tend to be attracted. A rally-base-drop area is the same as a drop-base-rally zone, only it forms in reverse and represents a supply that sellers are attracted to. A point to note is that both the drop-base-rally and rally-base-drop areas are often viewed as reversal zones. Now, this does not mean they have to form at trend reversals; although they do, they can form within the prevailing trend to help facilitate buying at dips and selling into rallies or pullbacks. 

How Can You Identify Supply and Demand Areas?

  • Rally-base-rally demand zones and drop-base-drop supply areas tend to offer better performance when identified within a trend. The same can be said for drop-base-rally areas of demand and rally-base-drop supply zones; though these are found at trend reversals, they are also employed in corrections and pullbacks within the current trend.
  • Look for initial strong movement away from the zone. Was the initial breakout robust or sluggish? Supply and demand traders look for the former.
  • Duration away from the zone is an important consideration. Ideally, you want to see price action return to the area within a short period of time. Ultimately, this idea is to trade these areas with the trend as trying to trade a zone following a long time spent away from the area could have you trading against the trend.
  • It’s location. Where did the zone form? Was it alongside a trend, and does it make sense regarding market structure? For example, did the area form before breaking a notable price level on the chart? This could be opposing supply or demand or even a major Fibonacci level.
  • How is the base formed? Is it disorderly or compact? Ideally, you want an orderly, compact base to work with.

Supply and Demand Trading

It can help to think of supply and demand areas as decision points on a chart where active buying and selling were present and where unfilled orders may have been left behind that are tradeable upon return.

Figure 1 shows a daily chart of the EUR/USD currency pair. You will see that the area highlighted is a compact, rally-base-rally zone that formed within an early uptrend. You may also recognise that this zone represented a clear decision point, an area where a decision was made to push beyond the $1.0198 high in September 2022 (red arrow). Note also that the initial move out of the rally-base-rally area was strong, and the time spent away from the zone was short before returning to test the area. All of these points made the noted demand zone one of interest and a high-probability long opportunity. The first time back to a supply or demand area tends to be the higher-probability trade.

How traders approach these zones will be trader-dependent. Many opt to set pending orders (limit orders) at the upper and lower edge of the bases and position protective stop-loss orders at the opposite end of the zone. Some may even opt to wait for additional confirmation before entering a trade and this usually involves using a market order.

Figure 1: EUR/USD Daily Chart By FP Markets MetaTrader 4

Supply and Demand Areas FAQs:

  1. What are supply and demand areas?

Supply and demand areas offer traders four main trading structures: rally-base-rally and drop-base-drop areas and rally-base-drop and drop-base-rally zones.

  1. How can I trade supply and demand areas?

Several factors must be considered before trading any supply or demand area. These include assessing its location and the strength of the area’s initial move. The construction of the base and the time spent away from the area can also be considered.

  1. Where can I learn more about supply and demand areas?

Visit the FP Markets Academy, designed for new and experienced traders. There, you will find a selection of articles and videos on all key topics, including supply and demand.

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Source - database | Page ID - 39952

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