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Ask 10 high-performing traders what their favorite technical indicator is, and one indicator will make the list almost every time: Supply and Demand.
Supply and demand drives all price discoveries, from local flea markets to international capital markets. When a lot of people want to buy a certain item with limited quantity, price will go up until the buying interest matches the items available. On the other hand, if no one wants to buy a certain item, the seller has to lower the price until the buyer becomes interested or otherwise there won’t be a transaction.
The “accumulation and distribution” theory describes how trends are created. Before a trend starts, price stays in an “accumulation” zone until the “big players” have accumulated their positions and then drive price higher. They can’t just swamp the market with their full orders because it would lead to an immediate rally and they weren’t able to get a complete fill, thus reducing their profits.
It is reasonably safe to assume that after price leaves an accumulation zone, not all buyers got a fill and open interest still exists at that level. Supply and demand Futures traders can use this knowledge to identify high probability price reaction zones. Here are the six components of a good supply zone:
1) Moderate volatility
A supply zone typically shows narrow price behavior. Lots of candle wicks and strong back and forth often cancel a supply zone for future trades.
The narrower a supply/demand zone before a strong breakout is, the better the chances for a good reaction the next time typically.
2) Timely exit
You don’t want to see price spending too much time at a supply zone. Although position accumulation does take some time, long ranges usually don’t show institutional buying. Good supply zones are somewhat narrow and do not hold too long. A shorter accumulation zone works better for finding re-entries during pullbacks that are aimed at picking up open interest.
Good supply zones are somewhat narrow and do not hold too long. A shorter accumulation zone works better for finding re-entries during pullbacks that are aimed at picking up open interest.
3) The “Spring”
The Spring Pattern describes a price movement into the opposite direction of the following breakout. The spring looks like a false breakout after the fact, but when it happens it traps traders into taking trades into the wrong direction. Institutional traders use the spring to load up on buy orders and then drive the price higher.
4) Strong force leaving the zone
This point is important. At one point, price leaves the supply zone and starts trending. A strong imbalance between buyers and sellers leads to strong and explosive price movements. As a rule of thumb, remember that the stronger the breakout, the better the demand zone and the more open interest will usually still exist – especially when the time spent at the accumulation was relatively short.
When price goes from selling off to a strong bullish trend, there had to be a significant amount of buy interest entering the market, absorbing all sell orders AND then driving price higher – and vice versa. Always look for extremely strong turning points; they are often high probability price levels.
If you trade of supply areas, always make sure the zone is still “fresh” which means that after the initial creation of the zone, price has not come back to it yet. Each time price revisits a supply zone, more and more previously unfilled orders are filled and the level is weakened continuously. This is also true for support and resistance trading where levels get weaker with each following bounce.
6) Amateur squeeze
The Rally-Range-Drop scenario describes a market top (or swing high), followed by a sell-off. The market top signals a level where the sell interest got so great that it immediately absorbed all buy interest and even pushed price lower.
The amateur squeeze allows good and patient traders to exploit the misunderstanding of how market behavior of consistently losing traders. It is reasonably safe to assume that above a strong market top and below a market bottom, you’ll still find big clusters of orders; traders who specialize in fake breakouts know this phenomenon well.
Ready to start using Supply Demand in your trading strategy? Check out the BG Supply Demand indicator and incorporate it into your Trading now.