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.
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.