Supply and demand trading strategy for professional traders

If you haven't read the article on support and resistance lines, I recommend that you read it first in the article entitled "Support / Resistance levels and trend lines", and then move on to the advanced discussion in this article.

In that article, you learned the basics of trading using supply and demand lines. Starting with the basic concepts, such as how to identify an upward trend or a downtrend.

We will now explain how to trade at an advanced level using the supply and demand strategy.

The equilibrium supply and demand zone

Let's review the equilibrium zone a bit so that you don't forget it. An equilibrium zone is when the number of buyers and the number of sellers are equal. There are no shortages or surpluses that could lead to major price variations.

In simple terms, an equilibrium zone is a market condition that is lateral. A lateral situation basically means that there's no buyer or seller dominance. This, of course, means that the availability of assets and demand are balanced and set. We can therefore conclude that the lateral condition is an equilibrium zone.

If there is a zone of equilibrium in the market, is there also a zone of disequilibrium? If so, what is the link with supply and demand trading? That's the subject of this article. Read on!

Zones of imbalance in terms of supply and demand

Unlike the equilibrium zone, the imbalance zone is the extreme zone where prices can move significantly. In these extreme zones, there's generally a large difference between supply and demand.

These imbalance zones are often used to identify major reversal or retracement points in the market. How is this possible?

You have to remember that the zone of equilibrium is the result of haggling between buyers and sellers, while the imbalance zone is a different matter. This zone is formed precisely because of the trend and bias in price movements.

So it's not surprising that this zone is widely used by individual traders and banks to place large orders. And because the number of orders in this zone is so large, it's also often referred to as the high liquidity zone.

The high liquidity zone can offer low risk trade executions and great opportunities.

Although this zone seems like a good place to start looking for market reversals and continuation points, that doesn't mean it's a perfect zone. Remember, no one really knows where the market price is going to go!

So what is an example of an imbalance zone in a candlestick? Here is the basic structure of an imbalance zone in a candlestick.

First of all, you need to understand that there are 3 main parts to a candlestick. The body of the candle represents the zone of balance, while the 2 wicks of the candle represent the imbalance zones.

As the below image shows, there are 2 types of imbalance zones, namely the supply zone and the demand zone. A zone of supply is an area where there are many sellers willing to sell their asset, while a zone of demand is an area where there are many buyers willing to buy the asset.

Now let's look at a candlestick in the shape of a pin bar with a long tail on top, as shown in the anatomy of the candlestick. According to Steve Nison, a pin bar symbolises the strong interest of sellers in a market.

It's also advisable to take a short position if you see a new pin bar forming. The greater the difference between the length of the pin and the length of the body, the greater the selling pressure.

From the perspective of supply and demand, the anatomy of the candle illustrates the comparison between the quantity of an asset and the quantity of demand. The longer the wick of the candle, the greater the difference between the quantity of the asset and its demand.

The longer the upper wick (supply) compared with the lower wick (demand), the greater the downward pressure on the price. And vice versa.

This concept is similar to the basic support and resistance line concept. At the support level, the upward trend in price is greater, and vice versa at the resistance level, where the downward trend in price is greater.

But there's more to it than that: in the supply and demand zones, there can also be a breakout.

Types of imbalance zones

There are generally two types of imbalance zones: supply zones and demand zones. These two zones of supply and demand are also divided into price continuation zones and price inversion zones.

With a tendency towards price continuation, these zones of imbalance generally appear after a strong sideways movement in the market. The time required for price continuation can vary.

1. Drop Base Drop Supply zones (DBD Supply)

This zone marks the start of a further significant fall in prices. Drop Base Drop Supply (DBD Supply) zones are often used because prices often return to these zones after breaking a support or equilibrium zone.

2. Rally Base Rally Demand zone (RBR Demand)

This zone marks a further sharp increase in prices. Like the DBD supply zone, this is also the zone where prices retreat after crossing a resistance or equilibrium zone. From now on, we'll call this zone RBR Demand.

Price reversal zones

As prices tend to reverse, these imbalance zones appear when market prices reach a certain support or resistance level. The price that reaches this level decides to reverse and move away from the zone. The time it takes for the price to reverse and move away from the reversal zone can vary.

1. Rally Base Drop Supply zone (RBD Supply)

This zone marks the reversal of the price from an uptrend to a downtrend. After touching this zone, the price may not return, or may even reverse through the demand zone. This zone is called the RBD Supply.

2. Drop Base Rally Demand zone (DBR Demand)

The opposite of the RBD Supply zone, this zone marks the reversal of the price from a decline to a rise. After hitting this zone, the price may never return, or may even reverse after finding sellers in the nearest supply zone. From now on, this zone will be known as DBR Demand.

How do I draw an imbalance zone

Drawing an imbalance zone is much easier than drawing an ordinary equilibrium zone. In fact, in order to draw an imbalance zone, you'll use well-known candlestick configurations.

In addition to pin bars, there are several other candlestick patterns that can be used as a reference to draw imbalance zones, such as Engulfing, Harami, Piercing and Doji.

A trading system with supply and demand imbalance zones

Before going further explore trading using imbalance zones, always remember the 4 important rules learned earlier:

• Only sell on supply.
• Only buy on demand.
• Always look to the left.
• Always calculate risk in detail.
  

In fact, this trading system focuses solely on Pullback or Retest or Retracement entries. In addition, you can also enter using the Counter-Trend or Trend-following style. Here is the full configuration and explanation:

Market filter

To filter the market, first mark the imbalance zone on the daily or weekly time scale. This makes it easier to see the current price position when viewed on a larger scale. Take a look at the below example, which is a daily chart of the EUR/USD as an overall picture.

Trading configuration

The set-up conditions require you to not just look at the general trend, but at the current price position within broad time frames. This is why, in the market filter, you are asked to mark the imbalance zone on the basis of the daily or weekly time scale.

If the current price is in the demand zone, you should concentrate on finding buying opportunities over shorter periods. Adapt the time frame to your trading style. For example, for swing traders or day traders, use the H4 and H1 time frames.

Entry

As explained above, entries in this strategy can be made by Pullback, Retracement or a Retest in the area of supply and demand imbalance. The entry conditions are not in fact difficult; the more often the zone appears, the more valid it becomes.

For example, on the H4 chart, the zone has just appeared in pullback for the second time. You can therefore use a pending order to enter a long position on the zone.

In fact, some supply and demand traders place several pending orders in these zones. Some place them a few pips before the price enters the zone, while others place them at a price close to the end of the zone.

Nobody knows when the price will reject the zone. My advice would be to place your pending order at a price close to the end of the zone, which will minimise your risk, but will also allow you to make bigger profits. And one thing you shouldn't forget is that you should have placed your SL a few pips after the end of the zone.

Market exit: Trailing Stop Vs Breakeven

In terms of the exit rules of this trading strategy, traders generally use the Trailing Stop or move the SL to the breakeven point. But which is the best method to use for this trading system?

According to Sam Seiden, a renowned support and demand trader, the breakeven point is the best way to exit this strategy. You can apply it on the basis of calculating the risk/reward ratio.

For example, let's say you're using a risk/reward ratio of 1:3. According to Sam, you can only move the SL towards the break-even point when the price is rising with a floating profit of 2 times the set risk. This method was used by Sam after years of research into this trading system.