In today’s article, I’m going to show you the method I use to determine the strength of a supply or demand zone that’s formed in the market. Having an idea of how strong a zone is, will aid you greatly when trading supply and demand zones because you’ll be able to only take trades at the zones you know are the strongest, which will give you more successful supply and demand zone trades. Before we start, it’s really important that you’ve read the articles I’ve listed below, as you need to have the knowledge contained within these articles to be able to understand the method I’m going to be showing you today. I’ll be referring back to some of the things talked about in these articles in this article, so it’s best to give them a quick read just to familiarize yourself with what I’m talking about.
Here’s the articles….
The article below isn’t one you need to read, but I’d suggest reading it anyway as it contains useful information on what I’m going to be talking about today.
The Theory Behind The Method
Before I show you the actual method I use to determine the strength of a supply or demand zone, I want to give you a little bit of an explanation as to how the method works so you understand the basis as to why it works the way it does.
If you’ve read my “Using Order Flow To Understand How Traders Trade” article, you’ll remember I said the size of the trades the bank traders can get placed into the market is determined by the number of buy or sell orders entering the market at the time they want to get their trades placed. The bigger the size of the orders, the bigger the size of the trades they can get placed. Now the number/size of orders coming into the market is determined by the strength of the beliefs traders have about which direction they believe the market is going to move in the future. If lots of traders thought the market was going fall, they’d place sell trades because they want to make money from the drop they believe is going to take place.
So really, the size of the trades the bank traders can get placed, depends on what other traders believe about which direction the market is going to move in in the future, as their the ones who’s orders are going to be used by the banks to get their trades placed. What this means, is we can gauge how strong a supply or demand zone is, simply by understanding the strength of the traders beliefs about which direction the market was going to move in, right before the bank traders came into the market and got their trades placed to cause a supply or demand zone to form.
The main thing which traders use to determine which direction the market is going to move in is the trend, like we talked about in my “Understanding How Large Groups Of Retail Traders Trade” article. We know that most of the traders in the market will trade in the direction of the trend, and we know that by believing in the concept of trend, they also believe the longer the amount of time the market has spent moving in one direction, the higher the probability it has of continuing to move in the same direction in the future. This means that all we need to do to figure out the strength of a supply or demand zone, is look at how long the market was trending prior to the supply or demand zone forming, as that will give us an idea about how many traders were placing trades before the zone formed, which will in turn give us an indication as to how strong the supply or demand zone actually is.
The reason why we can determine the strength of a supply or demand zone from the size of the trades the bank traders placed to cause the zone to form, is because the size of trade they’ve placed, tells us how invested the banks are to that point in the market. If there were two supply zones that had formed, and we knew that out of the two zones one had been created by a much larger number of sell trades being placed, we’d know that zone has a better chance of causing the market to reverse once it returns, due to the fact the banks would want their largest trades to remain open if the market was going to continue moving in the direction to which they’ve got their trades placed.
Think about it like this……..
If you placed a 1 lot trade at 0.7000 and a 1000 lot trade at 0.6900, which trade are you going to want to remain open in the market ?
Of course it’s going to be the 1000 lot trade, due to the fact it has the potential to make you a lot more money than the 1 lot trade.
So if the market came down to the point where this 1000 lot trade had been placed, you’d be a lot more inclined to see it move back up again than if it came down to the point where the 1 lot trade had been placed.
This is the main premise my method is based on.
If we know where the banks have got a large trade placed into the market, we know they are likely to want that trade to remain open if the market returns. So a supply or demand zone we know has been created by the bank traders placing a large number of their trades, is more likely to cause a reversal to take place than a zone which has formed as result of them placing a small amount of trades.
Drawing The Zones Properly
Just before I get in to showing you the method I use to determine the strength of a supply or demand zone, I want to give you a quick little lesson in drawing the zones properly to make sure that you include all the points where the banks could have got their trades placed to cause a zone to form.
The image above shows a demand zone that formed on the 1 hour chart of USD/JPY. Most supply and demand traders would have marked the demand zone above in the same way I’ve marked it ( i.e you draw the zone from the last bearish candle that formed before the move up occurred and down to the most recent low that formed )
The problem is most of the buy trades the banks placed to cause the move up seen after the demand zone to take place, were not placed at the low of the demand zone marked with a black line, they were placed at the swing low I’ve marked with an X. The reason they were placed here is because the number of sell orders entering the market at this point is much greater than at the point where the demand zone low formed, which means the size of the buy trades they banks were able to get placed here, were much greater than the size of the buy trades they were able to place at the demand zone low.
Here’s the demand zone again, only this time I’ve re-drawn it to incorporate the low which we know would’ve formed as a result of the bank traders getting a large number of their buy trades to cause the move up to occur. I’ve also marked the other points where they could have got buy trades placed, so you can see how they’re kind of close together in terms of the prices at which they formed at.
When you’re trying to find out which lows ( or highs if we were looking at a supply zones ) have formed as a result of the bank traders placing their trades to create a supply or demand zone, just look for the ones that are close to each other in terms of the prices at which they have formed at. The lows in the image above have all formed at similar prices, which means they’re all likely to have been created by the bank traders placing buy trades to make the move up occur. You need to draw your demand zone from the lowest of these lows ( marked with a tick ) as this is the low created by the banks placing their largest set of buy trades. If it was a supply zone you need to draw it from the highest high as that would be the one created by the banks placing the largest number of sell trades.
Determining The Strength Of A Zone
Now that I’ve given you a little bit of background about the concepts behind the method I’m going to be showing you today, what I want to do next is give you a step by step walk through of how to determine the strength of a supply or demand zone that’s formed in the market.
One of the important things I should mention before we start, is that because we don’t actually know the exact size of the trades the bank traders have placed to cause a zone to form, it means we can’t determine how strong a supply or demand zone is when its on it’s own. Instead, we have to took at the zone in comparison to other zones that have formed during the same up or down swing and work out an order of which zones are stronger or weaker than others.
I know from looking at this image that out of these two supply zones, supply zone 1 is stronger the supply zone 2. The reason why it’s stronger is because of the size of the sell trades the bank traders got placed to cause the supply zone to form. To find out how big the sell trades were, you have to move the chart back to the point where the banks got their largest set of sell trades placed, as that will give you an idea of how many buy orders were coming into the market at the time the banks got their sell trades placed.
Here’s an image of what the market looked like immediately before the banks got most of their sell trades placed to cause supply zone 1 to form. The high I’ve marked with an X is the high that was created by the bank traders coming into the market and getting their first batch of sell trades placed.
What’s clearly obvious from a quick glance at the chart, is just how bearish the move down marked with a big red arrow makes the market look. This move down will have caused most of the traders on the 1hour chart and the time-frames below to be entering sell trades at the point I’ve marked with a red vertical line. The reason why so many would have been selling here, is because of what I spoke about in my “Understanding How Large Groups Of Traders Trade” article.
In the article I said how all movements in the market are trends, only not to every trader at the same time. The downswing marked above, although not looking like a downtrend on the 1 hour chart, is a downtrend to the traders on the time-frames below, which means most of the traders on these lower time-frames will have been entering short trades when the swing low marked with a red vertical line was forming. It’s important to note that lots of traders on the 1 hour will have also been going short when the swing low was forming, just not as many as there were going short on the lower time-frame.
When the market moves up after making the swing low, a lower high is made and another drop soon takes place.
Now instead of this drop causing the market to make another lower low, like it has done after every other time the market has made a lower high during this swing down, it moves back up back up again and creates a higher low. This higher low automatically makes a large number of traders less interested in placing short trades during any down-moves they see, because of the fact the market is not following the same basic structure they’ve been seeing take place during the whole swing down.
Shortly after the higher low has been made the market moves up again, and this time breaks through the lower high that formed before the higher low had been created. The break of the high would have caused a large number of people to enter long trades because it looked as though the market was about to start a big move higher. Before the banks came into the market and got their sell trades placed, the candle for that hour was looking very bullish, which meant lots of traders will have been placing buy trades, by the time the hour had come to a close, the banks trades had got their sell trades placed which caused the candlestick to become a pin bar.
So all in all, we know there were quite a few traders in the market going long at the point where the banks got their sell trades placed to cause supply zone 1 to form.
Let’s move on and take a look at supply zone 2 to see if more or less traders were going long at the time the banks decided to get their sell trades placed.
Now here’s an image of what the market looked like just before supply zone 2 formed. The point where the banks got their largest set of sell trades placed to cause this supply zone to form has been marked with an X to the far right of the image.
You can see that before supply zone 2 formed, the drop from supply zone 1 had caused the market to make a new lower low. This new lower low straight away makes the market look far more bearish than it did before supply zone 1 formed, due to the fact that before supply zone 1 formed, we saw the market make a higher low followed by a higher high, which we know would’ve caused a number of traders to think the market is about to move higher.
The lower low we see form before the creation of supply zone 2 does the opposite, it makes people believe further downside is going take place, which means after the low has been made and the market is moving back up again, less traders are placing long trades during the move up because they think the market is inevitably going to continue falling due to the new lower low.
This means the amount of buy orders entering the market at the time the banks got their sell trades placed to cause supply zone 2 to from, were considerably less than the number of orders coming into the market at the time they placed their sell trades to cause supply zone 1 to form. So when the market comes back up and returns to supply zone 1, the bank traders will be more inclined to place sell trades due to the fact a larger set of their trades have already been placed here. If the market didn’t turn at supply zone 1 and instead continued moving up past the highs, that would be a sign you’re going see further upside take place, because it means whatever sell trades the banks placed to cause supply zone 1 to form must now be closed, as they wouldn’t let the market move up past the point where they had got a large number of their sell trades placed, if they wanted the market to continue moving in the direction to which their trades had been placed.
I’m going to run through another example now because the one above isn’t that great to be honest, usually it’s much clearer which zones are stronger than others another with the zones in the previous example it was pretty close between the two.
Here we have two demand zones that formed on the 1hour chart of USD/JPY. The lows I’ve marked with X’s inside demand zone 1 are all the points where the bank traders could have got buy trades placed to cause demand zone 1 to form, and the low I’ve marked with an arrow is the only point where the bank traders got their buy trades placed to create demand zone 2.
In order to figure out which of these two demand zones is the strongest, we have to move the chart back to the point where the banks got their largest set of buy trades placed to cause the each demand zone to form.
To find the point where the banks got their largest set of buy trades placed, you have to locate the lowest low which could have formed as a result of them placing buy trades into the market before the move up creating the demand zone began. With demand zone 1 the lowest low is the one seen to the far left of the image. This is the point where the bank traders would have got their largest number of buy trades placed, due to the fact the number of sell orders that would’ve been entering the market at the time this low formed, will have been much greater than at the points where any of the others lows marked with X formed.
For demand zone 2, there was only one low that could have been created by the bank traders placing buy trades. The candlestick which created this low is the one you have to move your chart back to when determining the strength of the zone as you’ll see in a minute.
In situations where you’re trying to find the points where the banks got their largest set of sell trades placed to cause a supply zone to form, what you have to do is find the highest high which could have formed from them placing sell trades before the market dropped creating the supply zone.
In the image above you can see the drop which caused this supply zone to form took place after the market had made two swing highs. Both of these swing highs formed due to the bank trades placing sell trades, but the highest high which I’ve marked with a tick is the one that formed from them placing their largest number of sell trades into the market. The candle which created this high is the one which you’d need to move your chart back to when trying to determine if this supply zone is stronger than any others you have seen form in the market.
Here’s an image of how the market looked after I’ve dragged the chart back to the point where the banks got their largest set of buy trades placed to cause demand zone 1 to form. ( Marked with an X in the far right corner of the chart )
It’s clear from the image, that before the banks came into the market and got their first set of buy trades placed, a significant move down was in progress. This move down was not only significant to the traders on the 1 hour chart, but also to the traders active on all of the other time-frames in the market, all apart from the monthly chart.
The market arguably looks even more bearish on here than it does on the 1 hour chart. Because it looks so bearish, it means whatever traders use the daily chart to determine the direction of the trend, will have been placing short trades at the time the banks came into the market and placed their buy trades, due to the fact the market looks like it is in a long downtrend, and they believe the longer a trend has been in place, the higher the probability it has of continuing.
Because the market looked so bearish on virtually all the time-frames in the market, it tells us that a massive number of traders were placing sell trades at the time the banks decided to get their buy trades placed. These buy trades had to have been huge, as the only way the market could have moved up out of the demand zone is if all the sell orders from the traders selling were consumed by buy orders.
Lets take a look at the other demand zone to see if there were a lot of traders going short at the time the banks decided to get their buy trades placed.
The first thing you’ll probably notice, is the sharp move higher out of demand zone 1 makes the market look far more bullish than it did before the banks got their buy trades placed to cause demand zone 1 to form. We saw in the previous image how before the banks got their largest set of buy trades placed, the market had been trending lower on almost every time-frame in the market. In the image above demand zone 2 forms after a sharp move higher had taken place, which means most of the traders in the market will now not be interested in placing short trades on any moves down they see, due to the fact the sharp move higher has made them think the market is going to continue rising.
When the small swing lower which leads to the creation of demand zone 2 take place, very few traders are willing to go short because of the move higher, which means there’s not many sell orders available in the market for the bank traders to use to get their buy trades placed.
So in comparing the two zones, we know that demand zone 1 is stronger than demand zone 2 because the size of the buy trades the bank traders placed to cause demand zone 1 to form, were much much bigger than the buy trades they placed to create demand zone 2, due to the outlook of the market being much more bearish before demand zone 1 formed than before demand zone 2 formed.
Determining The Strength Of A Consolidation Supply Or Demand Zone
If you’ve read my “Using Order Flow To Understand How Retail Traders Trade” article, you’ll remember that I showed you how to compare consolidations against one another to find out which one was the most important/relevant in the market.
The same method I showed you in that article is what we’re going to use to determine the strength of any supply or demand zones that have formed from consolidations in the market. We first figure out the length of time each consolidation has taken place, and then whichever one is the longest is the one considered to be the strongest.
If you look you can see consolidation 1 lasted longer than consolidation 2. In total, consolidation 1 lasted for 63 hours whilst consolidation 2 only lasted for 28 hours. Because consolidation 1 lasted for a longer length for time it means the supply zone which formed when it came to an end is stronger than the supply zone that formed when consolidation 2 terminated.
The reason why is because when a consolidation forms after an up or down-movement has taken place, a large portion of traders in the market automatically assume it’s a signal the market is about to reverse and move in the opposite direction.
The longer the amount of time the market spends consolidating, the higher the number of traders there will be trading the consolidation itself, instead of trading in the direction of the movement seen prior to the consolidation. This allows the banks to get more trades placed in the direction of the prior movement because there’s more orders available for them to get their trades placed.
Well there you have it, that’s my method of determining the strength of supply and demand zones. I understand that a large part of what I’ve said in this article is highly discretionary and the main reason I didn’t write this article before was because I felt like it was too complicated to explain to people how to do it. Originally this was just going to be one article but when I started writing it, I realized that in order for people to actually understand the method, they have to be taught about how the banks get their trades placed and how other traders in the market trade, which in themselves are not easy concepts to explain to people, hence the reason for me creating the two articles seen at the beginning.
I hope that some of you reading this have understood the method presented in this article, if you haven’t then I’ll try to do some more examples on it in the future to make it a little bit easier to understand.
Thanks for reading, please leave any questions in the comments section below.