Supply and demand zones
Updated: May 8
When it comes to understanding processes such as price action movement and naked price trading, it is beneficial to understand supply and demand zones. Price movement is often an asymmetric process where many opinions exchange, creating chaotic behavior. Still, every so often, the buyers or sellers align on the same opinion and price with stronger participation, which forms supply or demand imbalance around that price, thus forming a supply or demand zone at a specific price location.
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 loses the value. There is a low value in having the chart completely clogged up, where the trader expects that every micro move of the price should retest some old historical zone and price reacting to it.
When it comes to efficient plotting of supply and demand zones on the chart, those are main variables that trader should follow, which increase the efficiency a lot:
-focus on freshest supply and demand zones
-focus on the strongest zones, those where price left the zone in a quick, strong move
-focus on nearest zones, do not plot 100 levels on charts, have only the nearest ones in sight, and plotted on a chart to keep the chart clean
-focus as much as possible on dense zones where the price was consolidating for a while before forming zone (multiple highs and lows), excluding single lows or highs as much as possible
The fresh zone always has priority over the old historical supply or demand zone because the statistical chance for order flow to be still participating in the fresh zone is higher than in the old historical zone. As the time passes, the traders will slowly liquidate positions over time, 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 a maximum of 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 is conceptual presentation of fresher or older zones:
A trader should be selective, it is not the job of the trader to have an 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, do not form an opinion. That way, traders can be patient and only focus on cleaner structures where there will be less confusion.
Below is an example of how NOT to plot supply and demand zones on the chart. Plotting every zone, no matter of its time decay, its size, or its relevancy to current order flow, will yield complete confusion and very weak edge:
Below is an example of which zones trader should focus on drawing them on the chart, mainly dense zone. Those have a 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
Something that often circulates around supply and demand traders is how wide should trader draw the zone; at which price levels did the 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 spend the longest time consolidating around (potential underwater volume)
-around which price was the strongest volume traded?
A trader should always zoom in as close as possible in the price action that resulted around the sup / dem zone to establish as accurately where the zone was actually formed, where is the potential underwater volume (traders stuck in negative positions). Using lower time frames is a must to establish that.
Zones should not be just drawn with some mediocre attempt of looking where the highs and lows are; instead, there should be certain price behavior that dictates how deep the zone should be drawn and where the trader should start incorporating it into his/her 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 pointing out on how supply and demand zones are formed. To understand the approximate size of the sup/dem zone, one needs to use volume and quick/strong rejections as a guide to see where the actual big traders rejected the move or absorbed key flows. The supply or demand zone will have its core size around the price where rejection was quick and very strong.
The method above, however, can be a bit complicated and not very practical for newer traders, which is why many traders use pinbar candles and their shadows/wicks as a 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 less-important supply and demand zones
This is one price behavior characteristic that took me the longest to get on board, it took a lot of observation, approaching price from a logical perspective, and on top of that, doing hundreds of statistical researches. It is one of the most elusive 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 a strong breakout and which one is not? When it comes to the trading of squeeze structures and rotations of trends or bounces, this is a critical part to understand. Absorptions.
Here are two factors on how to judge the importance of levels (already outlined above in the article to some extent):
1.freshness (time and being un-broken or un-tested).
2. symmetry (clean and symmetric behavior of price).
The fresher the supply or demand zone and order flow in it, the more chance it has to hold, because it is a higher chance that the order flow inside that zone (traders) have not yet liquidated their positions.
Symmetry, on the other hand, contributes with its consistency of behavior to the buildup of order flow around the key area, making the zone stronger.
For example, in a structure where the price is rejected 10 times a similar level, the order flow of limit orders and an active eaten market order will 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 back to back.
Too many traders put too much attention to old historical support/ resistance (supply and demand) levels, while the actual strength hides within fresh order flow 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.
Example, which zones should traders put more attention to and which zones less attention. Freshness variable:
Impact of consistency / symmetry
Many traders do not bother with doing historical statistical research, therefore never figuring out if there is an effective statistical edge in their approach to the price levels or trendlines they draw. An important thing to keep in mind is that asymmetric, non-effective price structures can not be back-tested since there is too much conflicting information inside the structure to put in a robust pattern. Or with other words, within the asymmetric structure, every trader sees what they want to see, because there is no real robust guide for the human eye or brain to notice the pattern within asymmetry that is dense with conflicting information.
If one puts an 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 an optimal edge, one has to look at what everyone is looking at because that creates dense opinion exchange of many traders at the same price level, creating a 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 behavior is the way traders should approach PA analysis. Effective price analysis comes from where many traders are following the same key levels as those levels are obvious. 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
-bounced relatively similar in the strength of behavior? (how many candles it took for the price to reject all the way)
-is price cleanly following bounces without significant over-shoots on candles
If all the above 3 variables are present on the supply/demand zone or the trendline that one is potentially looking at, then the chances are that that level is decent to observe or potentially trade on.
Or with other words, it is better to follow a level that bounced 3 times, rather than just 2 times, it is better to follow a trendline where 4 lows bounced precisely from the same trendline, rather than drawing a trendline where 2 lows follow the trendline but 2 of them are completely disconnected from that trendline. The more consistency of symmetry, the better. This is something that most traders overlook and force completely asymmetric levels or trendlines that decrease or have no edge.
Trader should be selective.
Below is an example of a poor trendline and an example with a more consistent/symmetric trendline:
Poorer trendline (in-consistency of behavior inside the structure that follows trendline):
Better trendline (consistency of behavior in a structure that follows the trendline):
Another variable is consistency and density in drawing the trendline should have priority over the extremes of price. Example below:
Trendlines should represent meaningful connections of price behavior in the current state, connecting it to the past state. It is important to fit the potential of price rotation/move based on its previous near-term movements, never should a trader try to explain price analysis in its own vacuum, it is all about context. When you draw on the chart, always ask yourself: What context do I fit this into? Can't find clue or context, not enough symmetry? Forget about it, do not draw anything, move on to the next setup instead where the context is clearer.
When it comes to supply and demand zones and their formed support/resistance areas, the time factor is going to have a huge impact. Why? Because order flow over time will re-position itself, that is a statistical, mathematical factor, meaning that the fresher 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 on your right side of the chart, not miles and miles on the left side, fresh order flow will be in newly formed structures, and if a trader wants to be quick in spotting rotations or continuations that is absolutely a must to understand.
The right side of the chart over the left side of the chart, day in, day out. Always a priority. Yes, historical price action does matter, but near-term-fresh price action always should have a priority.
The only exception where old order flow is significant is where trend stays intact, and there is heavy positioning on one side of the market along with 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 behavioral changes of structures.
Below is a 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 are drawn reject over 100 samples, thus they never know if their drawing method is valid or performs decently in the first place. That is why in 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 a priority to focus on, the majority of trend rotations come from such areas.
Condensed supply is a formed supply zone around a similar price area (printing several highs or lows at the same price). In contrast, initial supply is often a softer supply of only a single or perhaps 2 highs or lows, or sometimes more of them but forming a very shallow structure. In a 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 substantial volume traded.
Difference between initial supply and condensed supply:
Importance of whole / round numbers
Round numbers as well often provide good micro supply or demand zones with stacked orders. This is something that the chart does not show, and traders might make the mistake of just anticipating every round number to be a reject zone just by looking at a chart.
Level 2 tape / Bookmap / order books/market depth should be used to confirm if the round number is stacked and avoid guessing too much. The use of order flow tools decreases guessing and increases the edge for round numbers. For FX traders excellent substitute is using futures order data since FX brokers do not provide accurate order numbers.
Below example of large order sitting at the whole round number (LYFT day 1 of IPO), displayed on order book:
Another variable to identify the strength of the 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 the price retests it. Example of high volume formed demand (1st example) and supply (2nd example) level bellow:
To put it in perspective, this is not about cherry-picking the examples where a high volume supply or demand zone was formed, and it provided nice and easy opportunities for bounces. This article is about which variables the trader should listen 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 a large sample base.
There is plenty of better material on supply and demand online or in books, material in this article mainly revolves around concepts that are often not mentioned.