Technical Analysis · Intermediate · 5 min
Supply and demand zones: the idea
You can explain the idea behind supply and demand zones, mark a demand zone at the base of a strong move and state the limits of the concept.
Leaving in a hurry
Most of the time, prices drift: a little up, a little down. But sometimes a price leaves an area in a hurry. One candle covers more ground than the five before it combined, as if someone had bought everything on offer.
Supply and demand traders pay close attention to the places such moves start from. This lesson explains their reasoning, and how much of it is supported.
The base before the jump
The lesson on supply, demand and the order book showed that a price moves when buyers and sellers are out of balance. Supply and demand trading builds on that. It looks for small areas where the imbalance was so large that the price left them sharply:
- A demand zone is the small base of candles that a price left with a sharp move up.
- A supply zone is the small base that a price left with a sharp move down.
The reasoning goes like this. If the price jumped away from an area, buyers there wanted more than sellers were offering. Large buyers in particular may not have filled their whole order before the price ran away. If the price later returns to the base, some of that unfilled demand may still be waiting, and may push the price up again.
In the chart, a fictional decline pauses for three small candles between 56.58 and 57.23. Then candle 9 jumps from 57.11 to 59.50. The demand zone is drawn around the base candles.
How does this differ from classic support from the last chapter? Support is defined by repeated turns at the same area. A demand zone is defined by one strong departure. A later lesson compares the two.
How strong is the evidence? Research supports parts of the logic: Carol Osler's work on currency orders shows that orders do cluster at certain prices. But the specific rules of supply and demand trading, such as how to draw zones and when they work, have been tested very little. Reviews of technical analysis research, like Park and Irwin's, also warn that many apparent successes come from choosing rules after looking at the data.
Back to the base
Follow the fictional chart.
- Base: candles 6 to 8 hold between 56.58 and 57.23 with small bodies.
- Departure: candle 9 rises from 57.11 to 59.50, several times the size of a normal candle on this chart.
- Run: the price reaches 62.24 on candle 13.
- Return: a pullback reaches 56.87 on candle 21, inside the zone. The next candle closes at 58.36, and the price climbs to 62.
A supply and demand trader would have watched the zone as the price returned, with a stop below 56.55 in case the zone failed. That it held this time says nothing about the next one. Zones fail too, often after earlier visits have used up the waiting orders, which is the topic of the lesson after next.
Common mistakes
- Marking every pause as a zone. The departure must be clearly stronger than normal.
- Drawing zones too wide. A zone that covers the whole range explains nothing.
- Treating zones as walls. They mark where interest may be, not where it must be.
- Forgetting the evidence. The idea is plausible but little tested.
The takeaway
A demand zone is the base a price left in a hurry upward, a supply zone downward. The idea is popular, not proven.
Check yourself
Quick quiz
4 questions. Instant feedback, nothing is saved.
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1Tap the candle that left the base in a hurry.
Tap the chart.
Candle 9 jumped from 57.11 to 59.50, far larger than the candles before it. The strong departure is what marks the base as a demand zone.
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2What is the core idea behind a demand zone?
A sudden move away suggests demand exceeded the supply at those prices. Traders expect leftover interest on a return.
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3How does a supply zone look?
A supply zone is the mirror image: sellers overwhelmed buyers, and the price left the area quickly downward.
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4How strong is the evidence for supply and demand zones?
Research supports the general idea that orders cluster at levels, but the specific zone rules have not been tested much.
of 4 correct.