Supply and demand is a concept used in technical analysis that was made famous by Sam Seiden. Saying “supply and demand” is simply another way of saying support and resistance.
As you may already know, support and resistance are basic building blocks in technical analysis. Whether you are using indicators or chart patterns, they all follow the rules of support and resistance.
But supply and demand are not exactly the same as support and resistance. While support and resistance are usually single price points, supply and demand depict a price area. Despite this minor change, supply and demand work on the same principles of support and resistance.
Support and resistance or supply and demand are derived on the central concept of the basic functioning of an economy. They are also a vital part of the functioning of a free market.
When there is ample supply, the price reflects this by falling. Similarly, when there is an ample demand for the product in the market, it is reflected by price rising.
Thus, supply and demand simply depict the buyer (or in our context, the investor or trader’s) perception of the asset.
How Does Supply & Demand Work?
Supply and demand work exactly as they are made out to be. In a trading context of technical analysis, when the price of an asset reaches a potential area of supply, the price tends to fall.
This happens due to the ample supply, or rather the selling pressure in the markets.
Similarly, when there is more interest in the markets, you can expect to see the demand rising, thus creating a demand area.
Visually, trading with supply and demand is much better than trading with support and resistance levels.This is because supply and demand work over a price area. Thus, some element of subjectivity is removed from this type of analysis.
Instead of traders looking at exact price points, which may or may not be reached, supply and demand areas look at a defined price level, which can vary by a few pips. This is the area where there is high buying or selling interest in the markets.
The reason why the supply and demand areas are formed is based on investor expectation. Price never moves in a straight line but rather forms different levels of supply and demand.
In an uptrend, you can expect to see the areas of demand rising steadily, while in a downtrend, you can expect to see the areas of supply falling steadily. This sounds familiar to the concept of higher highs and higher lows and lower highs and lower lows.
As you can see, the concept of supply and demand ties in closely with the trend as well.
What You Should Know
While there are many concepts in the approach to trading with supply and demand, bearing the following three points can help you tremendously.
1. Start with a Reference Time Frame
It is important to use one time frame as your reference time frame. This forms your starting point and can help you to build context. It is recommended that you start with a higher time frame as your reference point.
Then, once you move to the lower time frame, you can take your cues given by the market by keeping the higher time frame context in mind.
In simple words, it is all about plotting the supply and demand areas on a higher time frame and using the lower time frames to trade off the levels.
2. Mind the Trend
While supply and demand based trading can be done independent of the trend, knowing which way the trend is can help you in the long term. Based on the supply and demand levels that form, you can gauge the developing trend.
This will help to ensure you stay within the direction of the major trend. This also allows you the opportunity to spot counter-trend trading strategies as well.
3. Validation with Indicators
Using indicators as a trigger to your supply and demand areas can be helpful. However, do not make the mistake of using too many indicators on top of the supply and demand concepts. This can make it quite complex and tiresome.
Based on the technical concepts of the indicators that you use (such as oscillators or volatility bands), you can neatly tie in these trading rules within the larger scope of the supply and demand areas.
In conclusion, while there are many different ways to trade off the supply and demand concept, it is recommended that you keep your strategy simple. Most importantly, do not make the mistake of expecting this to be the strategy that can get you big profits.
The markets can be irrational and it always pays to remember that, regardless of the trading concepts you use.