OverviewA full study of the laws of supply and demand is outside the scope of this user guide. However, the following basic ideas should be understood:
- When supply and demand are in equilibrium (balance), the price of an asset will trade sideways - often in a narrow range.
- When supply exceeds demand, there is no equilibrium (imbalance), the price of an asset will fall in order to attract buyers at lower prices.
- When demand exceeds supply, there is no equilibrium (imbalance), the price of an asset will increase in order to attract sellers at higher prices.
- Financial markets are fractal, and these same basic rules apply at any time-frame.
Finding the “true” supply or demand is not simple, since markets are complex, particularly since different participants operate on different time-frames. However, there are some tell-tale clues in the price action. Remember that areas of supply/demand equilibrium (balance) are observed as sideways price action. If price moves quickly and aggressively away from such areas we know that an imbalance was observed, and the direction of the move tells us whether demand exceeded supply or supply exceeded demand.
Due to the habits of the market participants there might well be residual supply (or demand) at the same level as the origin of the imbalance. In particular, the imbalance indicates that there were unfilled orders at those prices, those orders might still reside there.
Even in the absence of “institutional order flow” there are a number of other reasons why these sharp transitions from balance to imbalance are useful places to trade around. For example, the behaviours of break-out traders, trapped traders exiting bad positions, etc.
Let’s look at the anatomy of a transition from balance to imbalance. This example depicts a demand zone, but the same principals also apply for supply zones.
The main components are:
- Zone origin
- This is the area of balanced trading. It is usually characterised by a narrow range, with several small / weak candles overlapping.
- The indicator forms the zone origin from 1 or more consecutive “weak candles”.
- “Weak candles” are identified by being smaller than average, having a small body relative to total candle size, or closing near the middle of the candle.
- The zone extends from the origin to the right, and will continue as long as the zone is considered “live”.
- Exit leg
- This is the price action immediately after the zone’s origin. A strong exit move suggests a large imbalance in supply / demand.
- The indicator forms the exit leg from 1 or more consecutive “strong candles”.
- “Strong candles” are identified by being not small, having a large body relative to total candle size, or closing near the high (or low) of the candle.
Not all supply / demand zones are created equal. Some will behave “better” than others, that is, they are more likely to provide a tradable reaction when price re-visits the zone. The SD Zones indicator tries to identify good zones, and there are a number of parameters that can be tweaked for optimum results. In general, we are looking for a small to medium zone origin (not too many bars and not too few) and a strong exit from the zone.
The size of the exit-leg move is calculated from the top of the demand zone (or bottom of the supply zone), and its strength is determined as the ratio with respect to the height of the zone. For example, if the zone is 20 pips high, and the exit-leg is 60 pips, then the ratio is 3.
Actually, the indicator assesses exit-leg move in 2 ways:
- The strength of the initial candle existing the origin, which uses the “Exit leg ratio (initial)” parameter.
- The strength of the move over several candles, using the “Exit leg ratio (extend)” parameter.
When forming the zone origin, the indicator has an option to take into account the candle wicks or candle bodies. The default option uses the candle bodies for the top of the demand zones (bottom of the supply zones), and uses the candle wicks for the bottom of the demand zones (top of the supply zones).