Understanding Supply and Demand in Forex Trading

Understanding the reason why a currency pair moves is essential for the development of every forex trader. At the most basic level, price moves due to supply and demand imbalances in the market at any given time. Once you grasp this concept, you can view trading through a logical lens.

Today we will discuss supply and demand trading strategies in Forex. We will learn how to identify supply and demand levels and how to apply these levels within a comprehensive trading strategy.

Supply and Demand in Trading

The supply and demand concept is a core component of economic theory. The Supply and Demand rule states that if the supply of a commodity is high and the demand is low, this generates excess which drives the price down. Conversely, if the supply of a commodity is low and the demand is high, this creates scarcity, pushing the price higher.

Applied to the forex market, if the supply for a currency pair is high and the demand is low, it will drive prices lower. If the supply for a currency pair is low and the demand is high, this will drive prices higher.

The supply and demand of a currency pair is determined by various market participants, including governments, banks, investors, funds, and speculators. Their actions in the market shift supply and demand, causing price fluctuations. When you open a currency trade, you are participating in this supply and demand equation.

What are Supply and Demand Zones in Forex?

Supply and demand imbalances in Forex can be visually represented on price charts. Each tick on the graph reflects changes in traders’ attitudes towards the respective pair. Informed traders recognize that if many traders position pending buy orders at certain levels below the price during a downward movement, they do not expect the pair to go much lower.

Conversely, when large volumes accumulate at a level above the price, the supply will increase, causing potential price drops. Thus, traders should be aware of these crucial levels—Demand Zones and Supply Zones—on their charts.

Demand Zone

A Demand Zone is a price area below the current price action where there is strong buying interest. When the price reaches this level, pending buy orders get executed, resulting in a sharp price reaction.

For example, in the H4 chart of the USD/CAD Forex pair, a strong demand zone exists between 1.2400 and 1.2360. Every interaction with this level results in a price increase, indicating significant buying interest.

Supply Zone

A Supply Zone is located above the price action and typically contains a significant volume of sell orders. When the price reaches this level, these orders execute, causing the price to reverse downwards.

For instance, in the H1 chart of the GBP/USD Forex pair, each interaction with the supply area leads to a decrease in price.

Drawing Supply and Demand Zones

It is beneficial to draw supply and demand areas on the chart to visually identify where to trade as the price approaches these zones.

How to Find Supply and Demand Areas on the Chart

1. Zoom out on your trading time frame chart and switch to the next higher time frame (4x or 5x your trading time frame).
2. Identify turning points where prices have reacted sharply. A quick move down typically indicates a supply level, while a quick move up indicates a demand level.
3. Use a rectangular drawing tool to mark these zones on the chart.

Supply and Demand Analysis in Forex

A supply and demand-based trading system is a powerful way to trade Forex, focusing on price action. The rules are simple:

1. Buy when the price approaches a demand level and bounces upwards. Place a stop loss below the zone.
2. Sell when the price reaches a supply level and bounces downwards. Place a stop loss above the zone.
3. Hold your trade until the price reaches the opposite level or use price action analysis to determine exit points.

Trading Supply and Demand with Price Action Trade Management

Let’s apply these principles in a trading example. In the H1 GBP/USD chart, we see a demand zone where price bounces upwards, allowing for multiple trading opportunities.

As the price increases, it eventually reaches the nearest supply zone. If it breaks this level with high momentum, it suggests a strong bullish trend.

Example: Supply Side Trading

On the daily chart of USD/JPY, we identify a supply zone. After the price interacts with this zone and bounces downwards, we can initiate short trades.

If the price returns to the supply zone for a re-test and bounces again, this confirms another short opportunity.

Conclusion

The rule of supply and demand states:

• Price increases when demand is higher and supply is lower.
• Price decreases when supply is higher and demand is lower.

Supply and demand zones are critical turning points where price action is likely to reverse. By identifying these levels on Forex charts, traders can position themselves for potential market movements.

To draw a supply or demand zone, identify an area where the price action has created a swing level with a sharp price move and mark the area using a rectangular drawing tool.

Always remember to manage your trades effectively based on price action cues.