Supply and Demand Trading Strategy (Backtest And Example)

Last Updated on December 22, 2022

While many traders prefer to trade using technical indicators like RSI and MACD, others love to study a naked price chart and make their trading decisions based on price action. One concept that improves the analysis of price action is the supply and demand zones on the chart. Different from support and resistance lines, understanding supply and demand zones can improve your price action analysis and trading results. Wondering what a supply and demand trading strategy is?

The supply and demand trading strategy is a price action trading method that looks for trade entry opportunities around supply and demand zones areas in the chart that show periods of sideways price action before explosive price moves. As with supply and demand in economics, those zones tend to have huge sell orders (supply) and buy orders (demand) waiting to be filled.

In this post, we take a look at the supply and demand trading strategy. At the end of the article, we make a backtest.

What is supply and demand?

In the world of finance and economics, supply and demand is the most important concept — the law of supply and demand governs all market prices. In basic economics, it is well-known that supply and demand are what affect the prices of goods and services. Supply refers to the number of goods available to users, while demand refers to the need for the goods. The more supply we have on the market, the easier it’s for the asset price to fall. On the other hand, the more the demand the higher the prices because customers are willing to buy the item.

To put it in another way, when there is strong demand for goods or service, its price will rise, and when the demand fades, the price will retreat. On the flip side, when there is a lot of supply for the item, the price drops, and when the supply is low, the price might rise. This also applies to the financial markets, as the concept of supply and demand works the same way and can be used to determine the flow of price on the chart. In other words, supply & demand zones put the economic theory into a trading strategy using price charts.

In trading, most people confuse supply and demand zones as resistance and support areas where the price of an asset may slow down or reverse. While they’re similar to resistance and support lines at first glance, there are specific reasons why supply and demand zones are formed, which is what marks them out and makes them powerful. Using supply and demand in price action analysis and trading helps the trader understand the flow of market action and what the smart money is up to.

What is a supply and demand trading strategy?

The supply and demand trading strategy is a price action trading method that looks for trade entry opportunities around supply and demand zones, which are areas in the chart that show periods of sideways price action before explosive price moves. Essentially, the supply and demand trading strategy is about placing your orders according to zones where the price tends to reverse due to various factors.

As with supply and demand in economics, those zones tend to have huge sell orders (supply) and buy orders (demand) waiting to be filled, which are the primary reason the market reverses around such levels. Thus, a good understanding of supply and demand trading equips you with a comprehensive and powerful tool that can take your results to a new level. To better understand this trading strategy, let’s take a good look at the supply and demand zones.

Supply and demand zones

As we explained earlier, these are areas in the chart where the price moved sideways a bit before making a huge move.

  • Supply zone: This is a zone above the current price where the price had made a huge drop after a consolidation. There is usually more supply coming into the market around there — that is, the area tends to have a high number of sell limit orders waiting to be filled, and smart money may also be watching such levels to push the price down as they want. Depending on what had happened at that zone in the past, it can be categorized as a trend continuous base or down-base-down (DBD), a trend reversal base or rally-base-drop (RBD), or a flip zone.
Supply and demand
  • Demand zone: This is a zone below the current price where the price had made an explosive rally after some form of consolidation. In a demand zone, there are more buy orders, mostly as buy limit orders waiting to get filled. As a result, the market will typically rise when it moves to a demand zone. Depending on what had happened at that zone in the past, it can be categorized as a trend continuous base or rally-base-rally (RBR), a trend reversal base or rally-base-drop (DBR), or a flip zone. Note that in a reversal base situation, the price will typically start a new bearish trend that is opposite of the original one. See a DBR in the chart below:

Supply and demand zone

In a bullish trend continuous base (RBR), the asset’s price will typically pause and then resume the original trend, the bullish trend; the asset will keep rising. See the chart below:

Supply and demand example

What time frame is best for supply and demand?

Supply and demand zones are best used for day trading, so the best timeframe for using them in price action analysis must be an intraday timeframe. However, there may not be a particular specific best time frame for everyone. It would depend on the trader, their trading personality, and the timeframes they prefer to trade on.

One thing about using the supply and demand zone is that they are not to be used as a trade entry strategy on their own, but rather, as a part of a multi-timeframe analysis system. The zones only tell you about areas where the price is likely to reverse because of high demand or supply. It is up to the trader to develop a plan on how to use the zone based on their trading method.

For example, a day trader who trades on the 30 minutes timeframe may decide to use the supply and demand zones in the 4-hour timeframe to know where to look for trade entry setups. In this case, the trade would mark the zones on the H4 timeframe and step down to the 30-minute timeframe to find trade setups.

On the other hand, a trader who trades on the 15-minute timeframe may want to look for supply and demand zones in the H1 timeframe, while a scalper who trades on the 1-minute timeframe may look for the supply and demand zones in the 30-minute or 15-minute timeframe.

What can supply and demand be used for?

Supply and demand zones are used to know the potential areas where the price may reverse, at least, temporarily. There are zones with huge limit orders waiting to get filled, so smart money is always keeping an eye on such zones and would normally manipulate the price action around such places to fill their own orders.

As a retail trader, your job is to identify the zones, take note of them and watch what happens when the price gets to them. From how the price reacts at such places, you may know what the smart money would likely want to do next. In essence, your job is to read the footprints of smart money and follow their lead.

For example, if the price runs through a supply zone and reverses, it could be that smart money went for a stop hunt or a buy squeeze but actually plan to push the price down. A breakout below a local support level on the lower timeframe where you trade could be an indication to go short. In summary, you use the supply and demand zones to know where to look for trades based on how the market reacts at that level.

Does supply and demand really work?

Well, traders who use it claim that it works more often than not and makes them money overall. It could be true that it works when used the right way. But being a subjective strategy, different traders use them differently, so it may work for some people and not work for others depending on how they use it and the timeframe they trade on.

Those who use the supply and demand zones to identify potential trade reversal zones find out that the price does reverse around those levels most of the time. While that may be true, as you can see that on many charts, it could be a self-fulfilling strategy — that is, because many traders already know about those zones and are watching them, they trade in a way that expects the reversal to happen, so it happens from their actions.

For your own style of trading and strategy, the only way to know for sure if the use of supply and demand zones would improve your trading results is to backtest it. This may be difficult though, as supply and demand trading is often discretionary; you may have to have to do the backtesting manually if it is not possible to create a do that does what you want.

What are some examples of supply and demand?

You can easily see supply and demand zones on your chart if you know what to look for. We will discuss some examples here to show you how to find and use them in your trading. In the H4 chart below, you can see the demand zone labeled DBR (drop-base-rally). The base was formed after the price dropped to that level and made a huge rally.

Supply and demand example

In the chart, you can see that the price came down to that level again twice, and on both occasions, it reversed. Note the second reversal shown with the green dotted line. Assuming we want to trade that reversal when the price got to that zone, we would go down to a 15-minute timeframe to look for a trade setup. Our trade setup could be the breakout of a local consolidation on the 15-minute timeframe. See the chart below:

Notice the small box that shows the local price consolidation. A breakout above the high of that local consolidation marked by the top of the box would have been a signal to go long.

How do you find supply and demand in trading?

To find supply and demand zones in a chart, you have to study the chart and look for areas in the chart where the price made an explosive move after a minor consolidation. For it to be a supply zone, it has to be above the current price level. To be a demand zone, it has to be below the current price level.

Take a look at the chart below labeled RBD. Focus on the left end where the supply zone was drawn from. You can see the small price consolidation (about four bars) before the swift price drop. The price dropped until it reached the level that had a demand zone before it started to rally with speed. This level is a supply zone because, at the moment of the chart capture, the price is below the level.

How do you find supply and demand in trading?

In the second chart below, you can see when the price got to the supply zone again, the price reversed and began to drop. But the drop didn’t happen immediately; the price retested the level again before it dropped.

Supply and demand levels

Here is another example below: Notice the small price consolidation before the huge bullish candle. It is a demand zone as the captured frame shows that the price was still above the level. See the next chart when the price got to that level.

Supply and demand levels

In the chart below, you can see that the price retested the level twice before it rallied hard, forming some continuation bases along the way.

Supply and demand backtest

Notice the two continuous bases in the chart below:

Supply and demand trading rules

How to draw supply and demand trading lines

To draw the supply and demand lines, you need to first identify the zones. Once you have identified the zones, you use a rectangle tool to draw the zone from left to right. The height of the rectangle should be such that it captures the price consolidation that formed before the huge price move. Take a look at the chart below and notice how the rectangle fits the height of the small consolidation that precedes the swift price move.

Supply and demand settings

Notice how the zone is stretched to the right. In real time, you stretch your zone into the future.

Supply and demand trading strategy backtest

A strategy backtest with trading rules and settings is coming shortly.

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