Let us start with the different methods of identifying and plotting areas of supply and demand. The easiest zone to spot is when you have an obvious change in the direction of the trend. The candle that forms the pivot is the candle that is used to plot the zone. The following chart illustrates an example of a supply and a demand zone using this method. Simply place a horizontal line on the top and the bottom of the candle that forms the pivot, and fill the zone in with a rectangle tool if your trading platform has one.
Many times a daily candle will form too large of a zone. When this happens, simply bring up your hourly chart for the day that the zone was formed, place your zone around the hourly candle, and transfer that information to your daily chart. The top of the supply zone and the bottom of the demand zone are always going to be plotted at the extreme price point, but by using the hourly chart we can plot a narrower zone. You will see the importance of this when we discuss how to trade using supply and demand zones.
The next method of identifying zones is to look for an area where price has been trading sideways and in a tight range for several bars, and then dramatically shoots away from that range. On the left side of the chart, we see price trading in a tight range for 6 bars and then drops dramatically. The next time price came into the zone the trend reversed, giving us a short opportunity.
On the left side of the chart, we see price trading in a tight range for several bars and then shoots up dramatically. The next time price came into the zone the trend reversed, giving us a great buy opportunity.
The third method of identifying a zone is to look for areas of indecision roughly halfway through a strong downtrend for a supply zone, or vice versa for a demand zone. The easiest way to spot areas of indecision is a doji candle. After XOM opened, the price rallied one direction, reversed and rallied past the open in the other direction, and then reversed again closing close to where it opened.
The last method of identifying zones is by looking for gaps. When a stock gaps either up or down, there has been a sudden change in the balance of supply and demand. The price it gapped from is very likely to be a strong support or resistance line. You need to keep this in mind when managing your trades, but plotting the actual zone is the same as the above techniques. You need to look at the chart as if the gap was one big candle. The following chart illustrates this.
There are actually two gaps. For clarity purposes, I drew the candles in blue instead of red so you can see where the gap was on the chart before I drew the candle. The two areas that price gapped down from will likely provide resistance on the way back up, but we still draw our supply zone as if the candles were as shown.