Now that you understand what supply and demand zones are and how to plot them, it is time to look at how we use them in our trading.
By using supply and demand zones you do not need to use any technical indicators. Whether you are a long term investor, a swing trader, or a day trader, applying supply and demand strategies will make you a better trader.
Long term investing
If you are a long term investor, you will use a weekly chart. Long term investors usually trade more on fundamentals than technical data, but by looking at where the long term supply and demand levels are you can find better entry prices and also know when it is appropriate to hedge your position to protect profits. This is a weekly chart of Exxon Mobile. In the middle of 2010, XOM developed a strong demand zone around $56.00 to $59.00. Let us say that you thought XOM was a good long term buy, and you bought somewhere around the point “A.” Because you understand the concepts of supply and demand, you know that if XOM drops below $56.00, you want to exit your position because chances are extremely high it will continue to drop. You also know the major supply zone for XOM is around $92.00 to $95.00, leaving a lot of room for growth. The area around point “B” formed a fresh demand zone, and the area around point “C” created a fresh supply zone.
When price returned to the supply zone at point “D,” you now have a decision to make. This is a strong supply zone, so chances are high that the price will drop from here. You could just sell your stock and lock in your gains, but if you are subject to paying capital gains tax you may not want to sell because you have not owned the stock long enough for the gains to be long term capital gains.
You could also buy a put contract that would protect your gains. The best option would be to buy a JAN 12 95.00 put. This will protect you up to the third Friday in January of 2012. If price broke through the top of the supply zone, you would sell your put for a small loss. The reason you would buy the $95.00 strike price is to keep the cost of the time premium low. When the stock reached the demand zone formed by point “B,” you would execute your put option and sell your stock at $95.00. This would now qualify as long term capital gains. You could now repurchase the stock below $70.00 with a stop below the demand zone around $64.50.
If the only reason you would not want to sell your stock at point “D” is capital gains taxes, then you could sell a JAN 2012 90.00 call and use the proceeds from that to buy a JAN 2012 90.00 put. The prices would be about the same, so you are basically getting your put for free or at a very low cost. If the price breaks through the zone and stays above it, you will eventually lose your stock at $90.00, but by then it would qualify as long term capital gains instead of short term. Options can be executed at any time, but it is unlikely they would be executed before the expiration date unless the price went up dramatically.
If you bought back in around point “E,” you would repeat the same strategy at point “F” that you did at point “D.” At point “G,” you would close out your hedge position because of the strong demand zone formed a few weeks earlier.
Point “H” is a major supply zone, and I would close all positions. I would then wait for price to break through the top of the demand zone to re-enter the trade—assuming I still thought XOM was a good buy.
Swing traders would use a daily chart to look for trade setups. There are two basic swing trading strategies we can use by applying supply and demand principles.
I am sure you have heard the phrase “The trend is your friend.” When you trade with the trend, you enter your trade on a retrace of the current trend. Many traders like to use moving averages or Bollinger bands to find their entry points. By applying what we now know about supply and demand, we can use that knowledge to find our trade setups. For a short trade, we want to look for a bearish candle where the top wick is in a supply zone. For a long trade, we are looking for a bullish candle where the bottom wick is in a demand zone.
When trading this method, we do not necessarily care how strong the zone is, we just want to make sure a zone is there. Your stop should be a few pennies above the top of the supply zone for a short trade and a few pennies below the demand zone for a long trade.
This chart shows Microsoft (MSFT) in a strong downtrend. The price then rapidly moves up into a supply zone, giving us a bearish candle. We would enter the trade after the formation of this candle, placing our stop a few pennies above the supply zone.
Here are two long opportunities from the same demand zone. Note that the demand was a supply zone that turned into a demand zone when price broke through it. These trade setups are shown by the two green arrows.
It is important to note that not all retracements are going to be into an existing supply or demand zone, but the ones that do retrace into a zone are a higher probability trade and they allow us to define our stop price.
We can also trade against the trend. When trading against the prevailing trend, we are only looking for strong supply and demand zones. We enter the trade as close as possible to the bottom of a demand zone and as close as possible to the top of a supply zone. This gives us a higher reward to risk ratio because we are entering the trade closer to our stop price. The following charts show examples of a long and a short trade using this strategy.
The red and green arrows show where price moved into our supply and demand zones. We do not wait for a confirmation candle—instead, we just take the trade and set our stop a few pennies above the supply zone and a few pennies below the demand zone. Since our risk is determined by the difference between our entry price and our stop you can see that this strategy has a considerably higher reward to risk ratio.
This chart shows another short setup and also shows the price breaking through the supply zone. The supply zone is now a demand zone, and the next day, indicated by the green arrow, we had an extremely low risk, high reward trade at the bottom of the new demand zone.
This is where trading with supply and demand zones gets really exciting. If you are currently day trading stocks or options, you will throw away your indicators after reading this. The same principles apply to Forex and futures trading, but most people do not have the patience to wait for a good trade setup. If you are currently day trading forex or futures, I would still encourage you to trade with supply and demand zones. Be sure to realize you may not get as many trade setups as you might receive using indicators. Your trade setups will be higher quality setups, and you will make more money if you have the patience.
First, I would like to talk about the differences I have in regards to day trading compared to what is being taught in most day trading courses.
Diversification . Most day traders will tell you to spread your risk out among several positions. I disagree with this. It is harder to manage multiple positions in a day trading environment. There is nothing wrong with being in a few positions but no more than two or three at the same time.
Only trade stocks with high average daily volume . This seems logical, but a stock that normally trades low volume can very easily trade several million shares on a day with news. You will miss out on a lot of quality trades by only monitoring stocks with high volume.
Only trade stocks with a price between twenty dollars and one hundred dollars. I cringe every time I hear this one. There is absolutely no difference between trading 1000 shares of a $50.00 stock and trading 100 shares of a $500.00 stock. If you eliminate stocks under $20.00, you are going to miss out on a lot of great trades.
Only trade stocks with a high ATR. ATR, or average true range, is the average amount a stock moves in one day. I often hear traders say, “I like to trade $100.00 stocks because they have a higher ATR.”. Think about this for a minute. What you really want to look for is the average true range as a percentage of the stock price. A $10.00 stock with an ATR of twenty cents would be a better day trading stock than a $100.00 stock with an ATR of one dollar. The ATR as a percentage is two percent on the $10.00 stock and only one percent on the $100.00 stock.
Ok, now that I got that off of my chest, let us look at how we can apply our supply and demand knowledge to day trading.
In order to day trade, you need a minimum of $25,000.00 equity in your account. You really need to start with more than that because if you lose money on your first trade, your account equity will drop below the minimum required.
With the exception of liquid options with less than three days until expiration, I would highly recommend trading the stock and not the options when day trading. Your brokerage firm will give you four times the available cash to trade with. This is based on the cash balance in your account at the start of each trading day. If you have $30,000.00 cash in your account at the start of the day, you will have $120,000.00 in buying power. You can trade as many times as you want during the day, but you can never hold more than $120,000.00 in stock at any one time. If you make $10,000.00 profit on a trade, your buying power would still only be $120,000.00 for that day. Profits for the day do not count towards your buying power until the next day.
When we day trade, we want to use daily charts for our entry, and hourly or even down to 5 minute charts for our exits. The reason we use daily charts for our entry is the zones will be a lot stronger. When trading in this manner, we want to make sure they are strong zones and fresh zones, meaning price moved in and out of them quickly and they are not part of another zone. These zones have never been tested. Look at the following example.
In the daily chart, you see a fresh zone formed on the left side of the yellow rectangle. Six days later, price moves back up into the zone. We see a bullish candle very close to the top of the zone on the five minute chart. If you entered the trade after the close of that candle, you would have gotten an execution of $67.90. Your stop would be placed at $68.03. As the price started moving down, you would adjust your stop on every retrace. The horizontal red lines indicate where the stops would be moved to as the price went down. You would have eventually been stopped out at $66.11, leaving you a profit of $1.77 per share after commissions, assuming one penny in and one penny out for commission. If you had a $30,000.00 balance in your account, you would have been able to short 1750 shares, leaving you a profit of $3,097.50. If you would have been stopped out of the trade initially, you would have lost $262.50. This trade resulted in a reward to risk ratio of almost 12:1.
Many times price is moving rapidly towards a zone, and it can be a little scary to enter the trade. You have probably heard the saying, “Do not try to catch a falling knife.” Once you start to get the hang of plotting zones, you will realize that these are actually the best trades to take, and often times the trades with the best reward to risk ratios. Look at the following example.
On the daily chart, you can see a demand zone that started as a supply zone. It has never been touched as a demand zone. On the 5 minute chart, you can see price dropping rapidly down into the zone. The price hit $13.91 and reversed back up. You could take the trade as soon as it started back up, or you could wait until price came back down. The reversal shows you there is some demand there, and it is worth taking the trade.
Most of the time you will receive a second chance to enter the trade like we did here. You would have bought the stock at $13.91 or better on the second bounce, placing your stop at 13.62, three cents below the bottom of the demand zone. We place our exit at the bottom of the supply zone, based on the 5 minute chart, and move our stops like we did on the last trade. Again, the red horizontal line shows where we move our stop. You would have exited the trade 60 minutes later with a profit of $2.02 after commission. Your risk would have been 30 cents. Again, with a $30,000.00 account, you could have traded 8,500 shares for a profit of $17,170.00 in one hour. Your risk would have been $2,550.00, leaving you a reward to risk ratio of almost 7:1. As you will see in the next article on risk management, if we followed our risk management rules, we would not have traded that many shares. If our trading plan says we only risk 1% of our account on each trade, we would have only purchased 1000 shares, and our profit would be $2002.00 risking $300.00. The closer you can enter the trade to the bottom of the zone, the lower your risk would be, and the higher the number of shares you can purchase.
Let us look at one more day trading strategy using supply and demand zones. This is based on the fact that when a supply zone is pierced it turns into a demand zone, and when a demand zone is pierced it turns into a supply zone. The trade setups for this strategy are found pre-market. We look for stocks that have pierced a zone pre-market, indicating that the stock will gap up through a supply zone or gap down through a demand zone. When the market opens, we wait for a small pullback, and then when the price turns and continues in the direction of the gap we enter the trade, setting our stop a few pennies below the low for the day on a long position and above the high of the day on a short position. This is the only time we do not set our stops based on the supply and demand zones. The pullback shows us where the current supply or demand is, and if it breaks those levels we want out of the trade. Here is an example of this type of trade.
Notice how the price opened above the supply zone and then pulled back before continuing up. This is a typical candle when price gaps up through a supply zone. The reason for this is that a lot of limit orders are triggered at the open, causing the price to pull back temporarily.
Many times price will break through a zone on a daily chart, but there was still a day trading opportunity available.
Price opened up in the supply zone. If you took a short trade as a swing trade and set your stop above the supply zone, you would have been stopped out in the afternoon but as a day trade you could have made over $1.00 on the trade. This is not a bad day trading profit off of a $26.00 stock.
What if the stock price is at an all time high or all time low? When price is at an all time high or an all time low, we do not know where the supply or demand zone is located. In these situations we wait until a strong zone is formed and then take the trade the
first time price returns to the zone. A new zone will always be a fresh zone because price has never been there before.
It is important to make sure it is a strong zone, with price moving into and out of the zone rapidly. We do not want to be making trades against a trending stock unless we have a strong zone. The following charts illustrate this.
In this daily chart of Amazon (AMZN), a strong supply zone was formed designated by the yellow shaded area. The red arrow shows where price returned to the zone two days later, giving us a great short trade opportunity.
In this daily chart of Buffalo Wild Wings (BWLD), price moved up to the zone slower that AMZN did in the chart above. Even though price moved away rapidly, it was not as strong of a zone. As you can see, when price returned to the supply zone, it continued through the zone.