0 comments

Economics of Price Action: Supply and Demand Zones

by on March 22, 2014 6:49 pm BST
 

The economic principles of supply and demand states that in a competitive market, a unit price for a certain good will vary until the quantity demanded for the good will equal the quantity supplied of the good at the current price. Price action within a particular currency pair represents the same price determination.

There are four rules of supply and demand that can be observed on a price chart:

1. If demand increases and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.

2. If demand remains unchanged and supply decreases, a shortage occurs, leading to a higher equilibrium price

3. If demand decreases and supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.

4. If demand remains unchanged and supply increases, a surplus occurs, leading to a lower equilibrium price

Supply and demand, when applied to technical analysis, often represents an inflection point in the current trend and leads to a reversal. These zones differ from support and resistance levels because they tend to be a grouping of prices rather than a single price.

Traders will battle within these zones for what they deem is a fair and desirable price. If the demand for a currency pair at a given level tappers offer, price will begin to decline and result in a supply zone. Conversely, if demand for a currency increases and outpaces supply then price will increase and result in a demand zone.

The 4H Chart of GBPJPY shows levels of supply and demand. Price action will often consolidate within a small price range before breaking out. The four rules of supply and demand can be seen throughout price action.

4H Chart of GBPJPY

4H Chart of GBPJPY

Supply and demand zone trading is a great way to utilize low-leverage trading. Since the price range can vary, traders can use these zones to widen their entries and exits in order to remain in a trade without getting stopped out due to high-leverage.

For instance, a trader could place their stop-loss at the end of a zone instead of a typical support or resistance level that is prime or stop-loss gathering. Targets can also be geared towards the nearest demand or supply zone.