Supply and Demand Zones: What is it and How to Get Started
When I first started trading, it never hit me that the stock market is about supply and demand. Because of that lack of information, I saw my trades taking a lot of reversals. So my question was, how do I find supply and demand zones?
The answer is quite simple, to find a supply or demand zone look for a base candlestick and the following candlestick should be a strong direction to the upside or downside!
What is Supply and Demand Zones, Exactly?
Supply and demand zones are nothing but an area on a stock chart that show where strong sellers or buyers are – supply zones are where strong sellers sit, and demand zones are where strong buyers sit.
How Does Supply and Demand Zones Work?
The stock market is all about supply and demand–behind every transaction their’s a seller and buyer.
Let’s say you want to go to a Taylor Swift concert, and you buy the tickets for $300 each. Now let’s say that the millions of die-hard fans also want the tickets, when there’s only thousands to be sold. As a result, there’s a huge demand for the Taylor Swift concert tickets, and the tickets quickly sells out.
However, because the demand is astonishly high, some people are willing to pay $800 for the tickets. Now let’s say that one person offers to buy a concert ticket for $800 to someone who already bought one. That person, who bought it, sees an opportunity to make profit and agrees to sell it for $800.
That’s just like a supply zone in the stock market. When the price of a stock reaches a certain level, there are more people willing to sell than to buy–as a result, the price may decline as more people sell their shares.
Let’s say that the people producing the tickets decide to restock, and increase their price to $800. This means that there’s still a high demand for the Taylor Swift concert tickets, but fewer people are willing to buy it because of higher price. As a result, the tickets may not sell out as quickly as they did before.
That’s just like the demand zone in the stock market. When the price of a stock reaches a certain level, there are more people willing to buy it than there people willing to sell it. As a result, the price may increase as more people buy more shares.
Why Does Supply and Demand Zones Work so Well?
Supply and demand zones work so well because they’re usually formed by institutional traders. Institutional buying and selling of a stock is extremely powerful and can move the price of a stock.
How to Identify a Supply Zones?
To find a demand zone, you have to look for a consolidating candlestick, followed by an explosive to the downside.
How Identify Demand Zones?
To find a demand zone, you have to look for a consolidating candlestick, followed by an explosive to the upside.
Invalid Supply and Demand Zones
A supply or demand zone are valid areas to trade until it has been invalidated by the price of the stock. The way price action invalidates a supply or demand zone is when it has broken through the area.
Here’s a picture example of a supply zone being invalid:
How to Identify the Strength of a Supply and Demand Zone
There are 3 levels of strength to supply and demand zones:
- Strong: A strong supply and demand zone is when price action hasn’t even touched the zone or is about to for the first time.
- Semi strong: A semi strong supply and demand zone is when price action has been rejected or supported a few times.
- Weak: This is when supply and demand zone allow price action to consolidate and inch up higher or lower for longer periods of time.
Every time, price action continues to test a supply and demand zone, it gets weaker and weaker because it’s slowly taking out those buyers or sellers.
Pros and Cons of Supply and Demand Zones
Pros
- Potential trade opportunities for a reversal in trend.
- Helps with risk management
Cons
- Time consuming to find zones
- Can be very big areas
Who Should get into Supply and Demand Zones
A variety of traders can use supply and demand zones as they provide a great strategy for those who rely on technical analysis.
Supply and demand zones are a great way to identify opportunities for entries and exits whether it’s a day trade or a swing trade.
How to Trade Supply and Demand Zones in 6 Steps
Step 1. Identify Supply and Demand Zones
Trade stocks that respect supply and demand zones–such as S&P 500 ($SPY) or Invesco QQQ ($QQQ), and draw the supply and demand zones.
Step 2. Determine the Strength of the Supply and Demand Zones
You want to determine the strength of the supply and demand zone by looking at bigger timeframes, such as the monthly and weekly timeframe.
The smaller the timeframe, the weaker the zones are.
Step 3. Determine the Market Trend
Always analyze the overall market. If you’re trading stocks, always look at the indicies that lead the market.
Step 4. Determine Entry and Exit Points
Determine where the entry and exit points are.
Step 5. Watch Price Action
Watch the price of the stock make sure you take profits, or to see if you need to exit the trade.
To Sum It Up
Identifying supply and demand zones can help you predict market conditions on whether you’re bullish or bearish on the stock. As soon as the supply and demand zones gets broken through, it is no longer valid.
But to get better understanding about the overall picture, it’s a great idea to see how supply and demand zones react with certain resistance, and rejection levels.
If you’re interested in learning how to critical resistance, and rejection levels take a look at this article, “How to find support and resistance levels for stocks in the share market“.
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