A Complete Guide to Supply and Demand: How to Use It 

What is Supply and Demand? 

The concept of supply and demand applies to many businesses and industries, and the foreign exchange market is no exception. The lack of supply of an item would naturally bring the demand of said item higher. On the other hand, the excessive supply of an item would result in the lack of demand for the item. This see-saw relationship between supply and demand was written by Philosopher John Locke in his 1691 publication “Some Considerations of the Consequence of the Lowering of Interest and the Raising of the Value of Money” ^[1]. 

A real-world example would be the recent prices of gas. As of 26 August 2022, gas prices in the European region rose to ten times the average level. This can be heavily credited to the Russia-Ukraine war which led to a reduction in supply of oil, leading to higher demand and therefore, higher prices ^[2]. 

What is Supply and Demand in Forex? 

The relationship between supply and demand falls neatly into currencies as well. Investors often use technical and fundamental analysis to determine which currency will rise in value. Understanding the dynamics of supply and demand will help a trader be better equipped to understand current price action and future price movement in the foreign exchange market.  

How to Identify Supply and Demand Zones? 

Supply and demand zones encompass a similar idea to the concept of support and resistance. Supply zones work in the same vein as resistance, and demand zones as support. This also equates to the idea of selling at supply zones and buying at demand zones.  

To identify supply and demand zones, one must first understand basic market structure. There are two general ways a market can move; a reversal or a continuation. A reversal encompasses Rally-Consolidation-Drop or Drop-Consolidation-Drop structure. While a continuation covers Rally-Consolidation Rally or Drop-Consolidation-Drop ^[3]. 

Reversal	Rally-Consolidation-Drop (RCD)
Reversal	Drop-Consolidation-Rally (DCR)
Continuation	Rally-Continuation-Rally (RCR)
Continuation	Drop-Continuation-Drop (DCD)

The common denominator between all four market structures is the presence of a consolidation. These consolidations are important because they serve as either supply or demand zones that traders can use.  

To gain more insight into market structure, check out our Trend Analysis Complete Guide at the Vantage Academy. 

How to Draw Supply Zones 

To draw a supply zone, one must first identify the market conditions they are in. As mentioned above, a trader would want to sell at a supply zone. Supply zones can be found at RCD and DCD market structures and are drawn from the highest wick to the lowest candle body within the consolidation ^[4].  

How to Draw Demand Zones 

Demand zones are used for buyers in bullish market conditions. Demand zones can be found at DCR and RCR market structures and are drawn from the lowest candle wick to the highest candle body within the consolidation ^[4].  

Laws/Rules of Supply and Demand 

When looking at a chart, there are many consolidation areas but what makes a zone reliable? It is based on three pointers, essentially the laws of supply and demand zones ^[5]. 

1. Time  

When talking about time, what it means specifically is time the market spent within the consolidation. The longer the consolidation, the more credibility a zone has. Figures 5 and 6 are examples of demand zones and the duration the market spends within the consolidation.  

In figure 5, the consolidation lasted 13 days on the H4 time frame with a strong bullish breakout after.  

As compared to figure 6, whose consolidation only lasted for approximately 2 days. The breakout that followed was choppy.  

2. Strength 

When it comes to strength, the focus would be the strength of the move after the market has moved away from the consolidation zone. The stronger the move away from the consolidation, the more credibility a zone has.  

3. Freshness 

Freshness refers to the number of times the zone has been re-tested. In the case of supply and demand, the lesser time the zone has been retested, the stronger the credibility. Note that the concept of freshness is unlike the concepts of support and resistance where the more times the market re-test a certain support/resistance, the stronger it is.  

	Time	Strength	Freshness
Strong Credibility	Long periods in consolidation	Strong breakout from consolidation	Market has not retested the zone
Weak Credibility	Short periods in consolidation	Weak breakout from consolidation	Markets retested the zone multiple times

Supply and Demand Trade Examples 

Supply Zone Sell Example –  

In Figure 11, the chart showcases a sell example. The supply zone denoted in blue fits all three laws of supply and demand. On the H1 chart, the consolidation lasted for approximately 48 hours with a strong bearish move away and it is the first time the market has entered the supply zone.   

In Figure 12, markets created a new low through the impulsive bearish move after tapping into the supply zone for the first time, further perpetuating the overall bearish trend.

Demand Zone Buy Example –  

Figure 13 reflects a demand zone with all three criteria in play. On the H4 chart, the consolidation lasted 14.5 days followed by a strong bullish breakout and market is entering the demand zone for the first time.  

The impulsive bullish move denoted by the green arrow in Figure 14 is a result of all criteria being met.  

Pros and Cons of Supply and Demand Trading 

Just like any trading system, no single one is perfect. It requires constant practise and good trading psychology to be able to use a trading system effectively.  

Pros – The laws surrounding supply and demand trading provides trading structure without ambiguity. Being governed by the most fundamental principle in economic theory, its success has withstood the test of time. 

Cons – The method of supply and demand trading isn’t a stand-alone trading plan. For its effectiveness to increase, it needs to be use in tandem with other technical analysis tools.  

Conclusion 

Supply and demand trading can be seen as an advanced form of the concept of support and resistance. While support and resistance are based on singular price points, supply and demand is defined by a price area instead. The laws around supply and demand provide additional scaffolding that limits uncertainty which serves as a huge benefit when it comes to trading.   

Can’t wait to apply the secrets of supply and demand trading? Try practicing it through your own forex demo account.  

References 

1. The Origins of the Law of Supply and Demand. Investopedia. https://www.investopedia.com/ask/answers/030415/who-discovered-law-supply-and-demand.asp#toc-adam-smith. Accessed 7 September 2022

2. Barrett, B. N. Why are global gas prices so high? BBC News. https://www.bbc.com/news/explainers-62644537. Accessed 7 September 2022

3. Lawler, J. (n.d.). Price Action Trading Strategy: Supply & Demand Zones. https://www.flowbank.com/en/research/price-action-trading-strategy-supply-demand-zones. Accessed 7 September 2022

4. Dubrov, T. Supply and Demand Forex – The Highest Accuracy Method | videos. The5%Ers | Funding Traders & Growth Program. https://the5ers.com/supply-and-demand-forex/#Supply_and_Demand_Forex_pros_and_cons. Accessed 7 September 2022

5. Supply and demand zones. Blog. https://www.tradethematrix.net/post/supply-and-demand-basics-in-trading. Accessed 21 September 2022