• Jan

Supply and demand zones

When it comes to understanding processes such as price action movement and naked price trading it is very helpful to understand supply and demand zones. Price movement is often asymmetric process where many opinions exchange, creating chaotic behaviour, but every so often the buyers or sellers align on the same size with stronger participation, which forms supply or demand imbalance around that price, thus forming supply or demand zone.

Those imbalances create potential quick rejection moves, if they are re-tested and often lure in more traders to protect those price zones from breaking higher or lower.

Conceptual presentation of order flow - supply and demand zone formations:

Plotting of zones should be done with some logical and robust approach. Often supply and demand traders tend to pollute charts with hundreds of levels, where the whole meaning of anticipating the rejections just loses the value. There is no value in having chart completely clogged up, where trader expects that every micro move of price should retest some old historical zone and price reacting to it.

When it comes to efficient plotting of supply and demand zones on chart there are main variables that trader should follow, which increase the efficiency a lot:

-focus on freshest supply and demand zones

-focus on strongest zones, those where price left the zone in quick strong move

-focus on nearest zones, do not plot 100 of levels on charts, have only the nearest ones in sight and plotted on chart to keep chart clean

-focus as much as possible on dense zones where price was consolidating for while before forming zone, exclude single lows or highs as much as possible

This means that fresh zone always has priority over old historical supply or demand zone, because the statistical chance for orderflow to still be participating in fresh zone is much higher than in old historical zone. As the time passes, the traders will slowly over time liquidate positions, that is the fact. Thus the fresher the zone, the more focus the trader should put on it. For this reason personally i only draw 1 to maximum 3 zones on chart maximum, no more than that. The freshest and the strongest zones get priority and those are to keep the focus on, once price retests them.

Bellow conceptual presentation of fresher or older zones:

Trader should be selective, it is not a job of trader to have opinion every second of market action, which supply and demand zones are relevant and which are not, my personal rule is: If it is not clean / obvious example, i do not need to form an opinion. That way trader can be patient and only focus on cleaner structures where there will be less confusion.

Bellow is example of how NOT to plot supply and demand zones on chart. Plotting every zone, no matter of its time decay, its size, or its relevancy to current orderflow will just yield complete confusion and no edge whatsoever:

Bellow is example of which zones should trader give priority to focus for drawing them on chart, mainly dense zones, those have higher statistical chance of delivering bounce once retested, or delivering breakout liquidation move if broken.

Chart example of sup/dem zone plotting (wider zones and smaller zones):

The width / height of potential supply or demand zone

One thing that often circulates around supply and demand traders is, how deep should trader draw the zone, at which price levels did zone actually start to form?

There are few factors to conclude with helping to define this:

-at which point of price / time was rejection the strongest where price left the zone

-where did price spent the longest time consolidating around (potential underwater volume)

-around which price was the strongest volume traded?

For this reason trader should always zoom in as close as possible in the price action that resulted around the sup / dem zone, in order to establish as accurately as possible, where the zone was actually formed, where is potential underwater volume (traders stuck in negative positions). Thus going to lower time frames is a must.

Zones should not be just drawn with some mediocre attempt of looking where the highs and lows are, instead there should be certain price behaviour that dictates how deep should the zone be drawn and where trader should start incorporating it into his analysis. Using the above 3 key factors should help to define it.

Technically understanding the size of zones is not a priority concept, it is just something worth to point out, on how supply and demand zones are absorbed or triggered in effect. To understand the approximate size of sup/dem zone, one needs to use volume and quick / strong rejections as guide to see where the actual big traders rejected the move. The proper supply or demand zone will have its core size around the price where rejection was quick and on very strong volume.

Method above however can be rather complex and not very practical for newer traders, that is why many sup / dem zone traders just use pinbar candles as guide to drawing the supply and demand zones, using higher time frames.

Bellow such simplified method using pinbar candles at the rejection starting points:

Important versus non important supply and demand zones

This is one price behaviour characteristic that took me the longest to get on board, it took a lot of observation, approaching price from logical perspective and on top of that doing hundreds of statistical researches. It is one of the most illusive topics when it comes to trading in general, which resistance and support is relevant where one can expect price reaction / rejection and where not? Which level might bounce big, or which level is likely to deliver strong breakout and which one is not? When it comes to trading of squeeze structures and rotations of trends or bounces, this is critical part to understand. Absorptions.

Here are two factors on how to judge the importance of levels (already outlined above on article to some extent):

1.freshness (time and being un-broken or un-tested or created).

2. symmetry (clean and symmetric behaviour of price).

The fresher the supply or demand zone and orderflow in it, the more chance it has to hold, because it is higher chance that the orderflow inside that zone (bagholders and rejection trades) have not yet liquidated their positions.

Symmetry on the other hand contributes with its consistency of behaviour to the buildup of orderflow around key area, making the zone stronger.

For example in structure where price rejected 10 times similar level the orderflow of limit orders and active eaten market order is going to be much higher and dense than around non symmetric level of single high or low. Again those are facts that on average hold if similar volume traded assets are compared neck to neck.

Too many traders put too much attention to old historical support/ resistance (supply and demand) levels, while the actual strength hides within fresh orderflow levels and not as much on the old ones. Old levels matter only if they have traded on huge volume, which is way above average volume.

Again another example, which zones should trader put more attention to and which zones less attention. Freshness variable:

Impact of consistency / symmetry

Problem is many traders just do not bother with making historical statistical research, therefore never figuring out if there really is effective statistical edge in their approach on the price levels or trendlines they draw. Important thing to keep in mind is that asymmetric non-effective price structures can not even be backtested, since there is too much conflicting information inside structure to put in robust pattern. Or with other words, within asymmetric structure every trader sees what they want to see, not what the actual data says, because there is no real robust guide for human eye or brain to notice the pattern within asymmetry that is dense with conflicting information.

If one puts asymmetric chart to 100 different traders, they will all come with different conclusions, different drawings, different trendlines and support or resistance levels. And for trading with edge that is bad, one has to look what everyone is looking at, because that creates dense opinion exchange of many traders at same price level, creating potential liquidation move that one can trade on.

Example of non-effective (asymmetric) price analysis :

Example of effective cleaner trendline / structure:

Following clean and symmetrical price behaviour is the way trader should approach PA analysis. Effective price movements simply come from many traders following the same key levels, but especially important the larger players and their trading attempts around such levels. When it comes to this concept in regards to supply and demand zones or trendlines in general the questions i ask myself to define better quality samples:

-has price bounced at least 3 times from the zone / trendline

-were bounces relatively similar in strength of behaviour? (how many candles it took for price to reject all the way)

-is price cleanly following bounces without significant over-shoots on candles

If all above 3 variables are present on the supply / demand zone or the trendline that i am potentially looking at, then chances are that that level is decent to follow.

Or with other words, it is better to follow level that bounced 3 times, rather than just 2 times, it is better to follow trendline where 4 lows bounced precisely from same trendline, rather than drawing trendline where 2 lows follow trendline but 2 of them are completely disconnected from that trendline. The more consistency of symmetry the better. This is something that majority of traders overlook and force completelly asymmetric levels or trendlines which decreases or has no edge whatsoever.

I repeat it again, trader should be selective, and by that i mean very selective.

Example bellow:

Bellow example of poor trendline and example with more consistent / symmetric trendline:

Poorer trendline (in-consistency of behaviour inside the structure that follows trendline):

Better trendline (consistency of behaviour in structure that follows the trendline):

Another variable is consistency and density in drawing the trendline should have priority over the extremes of price. Example bellow:

Trendlines should represent meaningful connections of price behaviour in current state, connecting it to past state. It is important to fit potential of price rotation / move based on its previous near-term movements, never should trader try to explain price analysis in its own vacuum, it is all about context. When you draw on chart, always ask yourself: What context am i fitting this into? Cant find clue or context, not enough symmetry? Forget about it, do not draw anything, move on to next setup instead where the context is clearer.

When it comes to supply and demand zones and its formed support/resistance areas, the time factor is going to have huge impact. Why? Because order flow over time will re-position itself, that is statistical mathematical factor, meaning that the more fresh that supply or demand is the more likely it is that order flow is still present in its previous form or new traders will react to it much more likely compared to any historical old price levels.

Simple rule: always focus on what price structures are doing right now in your right side of chart, not miles and miles on left side, fresh order flow will be in newly formed structures, and if trader wants to be quick in spotting rotations or continuations that is absolutely a must to understand.

Right side of chart over left side of chart, day in, day out. Always a priority. Yes historical price action does matter, but near term-fresh price action ALWAYS has a priority.

The only exception where old orderflow is significant is where trend stays intact and there is heavy positioning on one side of market along the trend (for example heavily shorted low float stocks over many days or weeks), or the example which i mentioned above such as heavy volume traded on those historical levels.

Fresh order flow vs old order flow:

Exceptions of old order flow that is still likely significant (strong trends where old sup/dem zones have not been tested or broken at all, example bellow):

Follow fresh order flow, fresh structures, and the key behavioural changes of structures.

Bellow is typical presentation of how many traders plot just about any noticeable historical support or resistance zone, with expectations that all of those zones might be important, while the reality is very far from that when it comes to consistency and accuracy of rejections of such levels based upon what was said all above since beginning of this post. Keep in mind, most traders do not backtest or collect the data based on their trading method. They do not collect the data on how their support or resistance levels drawn reject over 100 samples, thus they never know if their drawing method is valid or performs decently in first place. That is why on this article all key factors for drawing sup/res and supply / demand levels have been outlined, because there is significant research data backing those critical factors to increase edge.

Condensed versus non condensed (initial) supply and demand zones

Condensed sup/dem zone is priority to focus on, majority of trend rotations come from such areas.

Condensed supply is simply a formed supply zone around similar price area (printing several highs or lows at same price), while initial supply is often a softer supply of only a single or perhaps 2 highs or lows, or sometimes more of them but forming very shallow structure. In condensed supply zone price is rejected from that zone strongly, quickly and often on volume, while initial supply zones are softer are rejections with price often stalling around the zones without substential volume traded.

Difference between initial supply and condensed suppply:

Round numbers

Round numbers as well often provide good supply or demand zones with stacked orders. This is something that chart does not show and traders might make mistake just anticipating every round number to be reject zone, just by looking on chart.

Level 2 tape / Bookmap / orderbooks / market depth should be used to actually confirm if round number is stacked, to avoid guessing too much. Use of order flow tools decreases guessing and increases edge for round numbers. For FX traders very good substitute is using futures order data since FX brokers do not provide accurate orders numbers.

Bellow example of large order sitting at whole round number (LYFT day 1 of IPO), displayed on orderbook:


Another variable to identify strength of supply or demand zone is the volume at which price formed the zone. The stronger the volume, the more important the zone could be once price retests it. Example of high volume formed demand (1st example) and supply (2nd example) level bellow:

Again to put it in perspective, this is not about cherry picking the examples where high volume supply or demand zone was formed and it provided nice and easy opportunities of bounces. This article is about which variables should trader listen to in order to increase the edge on potential bounce plays of supply and demand zones, rather than just simply plotting highs and lows as the guide. Those examples are far from working perfectly, but the variables outlined on the post do matter in terms of increasing the edge slightly across large sample base.


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