Supply and Demand
|February 7th, 2013, 07:32 PM||#11 (permalink)|
Futures Experience: Intermediate
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"Supply and Demand" VS "support and resistance"
The following educational articles are provided to you as a courtesy of Advantage Signals, a former Forex signals service provider. Advantage Signals has terminated their services in 2012. However the articles are posted here with written permission from their owner. In reading them have in mind that the owner was not a scalper or even a day-trader but a Forex swing trader. In other words, the duration of a trade could last a few days. Also, in the Forex markets the total volume of transaction is not exactly known. That means, the trader can only make an educated guess based on the allure of the chart. When i have time i'll post the next article in the series.
"Supply and Demand" VS "support and resistance"
In this article we would like to expose the differences between "Supply and Demand" and "support and resistance".
If we had to explain the differences in one phrase, we would say that "Supply and Demand" is the only true "support and resistance". Let us explain this further. If you asked random novice traders "what is support and resistance for you?", one might reply the 200 EMA (exponential moving average), while another one might say, this or that trendline, or the piercing of a Bollinger Band, this or that overbought/oversold indicator, the extreme readings of some magic oscillator, a thousand other things, or any of a million combinations of all the above. Each trader can believe different things to be support or resistance, and one trader's support might be another trader's resistance. But Supply and Demand can only be one thing.
Let's examine a completely imaginary (hypothetical) situation, where we could have real-time access to all the world's open orders in the market. Let's say that current EURUSD price was 1.2500, and we could see that there were huge (institutional) buy orders waiting at 1.2350, and then at 1.2230, while there were huge sell orders waiting at 1.2660, and 1.2710. In this imaginary scenario, we would be able to make a lot money easily and almost without any risk, because we would know that as soon as price fell to the first strong demand level below current price at e.g. 1.2350 (where demand is much greater than supply) price would jump upwards and would keep going up until it met a point were supply exceeds demand. There can be no other mathematical outcome for price direction, it has to go up because demand at that level exceeds supply. No matter what any indicators, oscillators, trend lines, news, experts, or astrology and magic crystal balls suggest, price has to go up from a level where demand is much greater than supply. Similarly, when price reaches a level where the huge sell orders (bank, institutional etc.) are waiting to be filled, price can only go down, because as soon as the last (novice) buy orders are filled by the exceeding supply, price will collapse and keep going down until it meets demand that can cover all that supply.
But in the real world we don't have access to all the world's open orders. So how can we take advantage of Supply and Demand imbalances? How can we find price levels where demand is much greater than supply, in order to buy just above that level and enjoy a low risk entry and a high possible reward? Or how can we find price levels where supply greatly exceeds demand, in order to sell short just below that level?
Traders today have easy access to great trading tools. These are not the complicated indicators and oscillators that all lag price and only signal you after price has done something, and usually when it is too late to take advantage of the opportunity. The simplest historical-price multiple-timeframe charts have all the information you need in order to analyse Supply and Demand in any market. Let us show it to you.
The following example has of course been prepared with the benefit of hindsight (can't avoid that in examples), but as a subscriber to our signals service, you can see in real-time that Supply and Demand works like this:
Take a look at the level marked with the green lines. This is a level that contained remaining unsatisfied Demand after price left the level. How do we know that? From the outcome: price left the level with a strong rally that lasted, and moved prices a lot higher (more details on this in another educational article). This can only happen when Demand at some level is much larger than the Supply there. When the existing Supply was exhausted, prices rallied leaving behind big amounts of unsatisfied demand. Knowing this, we could enter a buy order at a price just above the start of the demand level, with a stop just below the level. Look at the market reaction next time price touched the top of the green level. You guessed right, price rallied again. This has nothing to do with a double-bottom pattern, the prices where the market reversed are not even close to a double-bottom pattern. The price where the market turned has to do only with the point that pre-existing unsatisfied demand starts (at the top of the marked level, although the price could have reversed anywhere in that level). Take a look at any other level, and you will see the same thing happen again and again. Let's take the blue level for example. This is a Supply level that contained unsatisfied Supply when the price left the level, and we know that because of the way price left the level (sharp drop) and from how far price moved before it managed to return back to the level. When price left the blue level initially, the supply there was so much larger than the demand at that level, that price collapsed and kept going down for a long time and distance, leaving behind large unsatisfied amounts of Supply. Knowing this, why not enter a sell order just below the level, and take advantage of the existing supply there for a low risk entry? Would that level and our trade definitely work? No, but chances would be on our side, and that's the most important thing in trading.
Think about this: a novice trader might want to buy up there, right below the supply level marked in blue, because some moving average turned up, or some oscillator suggested accelerating prices upwards, or because the news were really good. What that novice trader doesn't know is that he/she will be buying close to a level where there is a ton of supply waiting to be filled, and prices cannot move further up unless all of that supply can somehow be covered by new incoming demand. Chances are against the novice trader making that mistake, and any professional trader would be happy to sell to that novice buyer near that supply level.
So that's the difference between "Supply and Demand" and "support and resistance", these two concepts, strategies, call them what you like. Support or resistance can be anything that any trader thinks can affect the price in any way. And one trader's support might be another trader's resistance or the opposite. But Supply and Demand can only be one thing, and that is the true, existing, unsatisfied supply and demand in any market, predictable in a reliable way by those that know what to look for, how to evaluate levels, and have a rule based strategy and plan to follow, thus having the chances on their side when trading. Not all levels work, but if a supply and demand trader can enjoy an acceptable win/loss ratio, and a great reward ratio, what more would someone need in order to be a successful trader? (Well, there are a few things, but that's the topic of another article!)
Will all levels work? Of course not, but enough will work to allow an experienced supply and demand trader to profit from the markets. The reasons why a level might not work are many. Imagine a huge multinational company having the need to sell billions of euros to buy another currency. They might chose a demand level to do that in order to satisfy their own supply, causing any demand level to fail badly. Would that stop us from trading the next demand or supply level? Of course not. Long-term the chances are on our side, and every time we see a solid demand or supply level that meets all our criteria, we will be interested in placing an order in the market.
Please note, in this article we only explained the difference between "Supply and Demand" and "support and resistance". We have not covered the way to evaluate the levels, the things to look for, and the rules to follow. This will all be part of the next educational article.