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10 Things You Can Learn From The World’s Best Traders
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Sunday, 27 October 2019

Happy Diwali

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May the light that we celebrate at Diwali show us the way and lead us together on the path of peace and social harmony.
A festival full of sweet childhood memories, a sky full of fireworks, mouth full of sweets, a house full of diyas and heart full of joy. Wishing you all a very happy Diwali!
May the festival of joy become more beautiful for you and family. All your new ventures get success and progress.
Happy Diwali!
Let each diya you light bring a glow of happiness on your face and enlighten your soul. Happy Diwali!


Saturday, 12 October 2019

Banknifty Strategy

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Option Strangle (Long Strangle)


The long strangle, also known as buy strangle or simply "strangle", is a neutral strategy in options trading that involve the simultaneous buying of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date.
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Buy 1 OTM Call
Buy 1 OTM Put
The long options strangle is an unlimited profit, limited risk strategy that is taken when the options trader thinks that the underlying stock will experience significant volatility in the near term. Long strangles are debit spreads as a net debit is taken to enter the trade.
Unlimited Profit Potential
Large gains for the long strangle option strategy is attainable when the underlying stock price makes a very strong move either upwards or downwards at expiration.
The formula for calculating profit is given below:
  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid OR Price of Underlying < Strike Price of Long Put - Net Premium Paid
  • Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Net Premium Paid


Limited Risk
Maximum loss for the long strangle options strategy is hit when the underlying stock price on expiration date is trading between the strike prices of the options bought. At this price, both options expire worthless and the options trader loses the entire initial debit taken to enter the trade.
The formula for calculating maximum loss is given below:
  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying is in between Strike Price of Long Call and Strike Price of Long Put
Breakeven Point(s)
There are 2 break-even points for the long strangle position. The breakeven points can be calculated using the following formulae.
  • Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
  • Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Example
Suppose XYZ stock is trading at $40 in June. An options trader executes a long strangle by buying a JUL 35 put for $100 and a JUL 45 call for $100. The net debit taken to enter the trade is $200, which is also his maximum possible loss.
If XYZ stock rallies and is trading at $50 on expiration in July, the JUL 35 put will expire worthless but the JUL 45 call expires in the money and has an intrinsic value of $500. Subtracting the initial debit of $200, the options trader's profit comes to $300.
On expiration in July, if XYZ stock is still trading at $40, both the JUL 35 put and the JUL 45 call expire worthless and the options trader suffers a maximum loss which is equal to the initial debit of $200 taken to enter the trade.
Note: While we have covered the use of this strategy with reference to stock options, the long strangle is equally applicable using ETF options, index options as well as options on futures.





Saturday, 5 October 2019

My 10 price action secrets

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My 10 price action secrets

Top secret price action secrets

Through years of price action trading, I’ve found that some things work better than others. I’ve completely modelled my trading style to reflect this, but I realise it’s not always easy for beginning traders to pick up on those subtleties. That’s why I want to save you a lot of time and go over what I believe are the most important price action secrets you will want to know.

These are the tips that will take you from price action beginner to being able to employ a solid and profitable price action strategy.




1. Multi-candle patterns are more reliable


The more candles a specific pattern contains, the more reliable it usually is. 3 candle patterns are better than single candle patterns. 30 candle patterns are usually better than 3 candle patterns.
Here’s an example:
Head and shoulders pattern

Patterns like head and shoulders, double and triple tops are among my favourites, exactly because of this reason. They consistently result in higher probability trades, which is what we’re all after. It doesn’t mean that a good pin bar setup won’t work, it just means there’s a higher probability of having these multi-candle setups resulting in a winning trade.

2. Wait for confirmation


Confirmation means that instead of entering when the pattern completes, it’s often helpful to see if the price will follow through. To make sure that I get confirmation, I enter just a little bit above or below the pattern, depending on which direction I suspect the price will go. This way, you can avoid fake-outs where price reverses on you, leaving the inexperienced traders in the cold.

Seasoned traders know to wait for confirmation.

Also don’t get into the habit of entering trades before the pattern completes. It’s tempting to want to enter when the last leg of a head and shoulders pattern is almost complete as you would get a better price, but it’s just as likely that the price reverses before the price action pattern completes, leaving you with a loss instead of the result you hoped for. Waiting for pattern completion shows patience, which is a personality trait every trader should have.

Here’s an example:
Confirmation 1

Here, we can see an uptrend where suddenly, price seems to stall a little bit. It consolidates sideways until quite a large pinbar shows up. Now you could do two things: jump in immediately or wait and put a sell stop a few pips below the low of that pinbar.

These are the candles that follow:
conf 2

As you can see, price didn’t hesitate and made a move higher. The impatient trader would have opened the order and very likely have its stop loss hit for a loss. The pro price action trader however would find that his sell stop would have never been hit and didn’t have lost any money.

Now which scenario do you prefer?


3. Know where to place your stop loss


Knowing where to place an order is just the beginning. Where do you place your stop loss? Fixed pips stop loss levels are hardly a good approach since the market volatility can change and every trade should be looked at within the context of the recent market history. There are a few strategies to place stop losses like a boss, and I’m going to share them with you.

Stop loss above the price action

Engulfing bar with stop loss
This is the easiest (and in many situations the best) option. When you see a price action pattern, you take the high of that pattern, add a few pips (± 5) and place your stop loss there. This is a good strategy because many times, the price will not go further than the high or low that the price action pattern created.

The drawback of this approach is that depending on the pattern, your stop loss might be quite large. A large stop loss means a smaller R:R, so you’re taking more risk to get the same reward. Nevertheless, in many cases, this is a valid approach. Have a look at this bearish engulfing bar, where you would place the stop loss a little bit above the pattern.



Stop loss half-way the pattern

Pinbar long wick SL halfway

When the pattern is so large that it’s realistically not possible to put your stop loss above the pattern, this could be another option.
It often happens with pin bars with a very long wick. It is riskier than our previous option though, since there is more of a possibility that the price will actually retest certain levels, as long as it stays within bounds of the pattern. But taking into account R:R, this can still be a good approach.




4. Always look for confluence


This is absolutely one of the most important secrets you have to know about. Confluence is everything.
So you’ve found a sweet price action setup. Great! Now make sure it has confluence, meaning that it coincides with other valid signals that support your trading idea. Here’s a triple top and previous high confluence:
Triple top confluence
These signals can come from a multitude of sources, but here are a few that I sometimes use in my trading:
  • Price action pattern happens at a meaningful support or resistance zone
  • Divergence on RSI
  • The pattern happens at a fibonacci retracement level
  • The pattern happens at a pivot point
  • It’s a break and retest setup

The very simple rule is: the more confluence you can have, the better the setup is.


5. Tell a story of what happened


Every chart tells a story. It might be a story of clear direction or a story of messy back-and-forth battling between buyers and sellers. In a similar way, we can talk about clean price action vs messy price action. It is up to the trader to find the story and better understand what the market might do.

Unclear story

Messy price action
From this chart snapshot, we can create our story:
The buyers were initially in control and pushed the price quite high. Eventually, they hit a resistance zone and had trouble keeping the price at this level. Sellers regained control and violently pushed price back down. But the buyers won’t just give up! In the second wave, they move the price back up until – you guessed it – sellers blocked their path and regained control.

This goes on for a couple of times and is characterised by lots of strong up and down moves, lots of candles with long wicks combined with candles with large bodies and – most importantly – a general lack of clear direction. You can define some resistance and support zones, but the price action is rather messy and it is not something I would trade.


Good story

Clean price action
Let’s go about creating our story again:
Clearly, in the left part of the chart snapshot, the buyers are in control. We see large green candles pushing upwards with very little counterweight from the sellers. There is a slight pause on the way up, this is what we would call a consolidation. The buyers catch a break, so to speak. After this consolidation period, we again see a strong push upwards. Candles are mostly defined by large bodies and relatively small wicks.
Now I want you to focus on the sequence of 4 candles at the top of the structure. At some point, we can see a large bullish candle, followed by a small bearish pin bar followed by a rather large indecision candle (the one with the long upper and lower wicks) and finally a strong bearish candle. This should already ring the alarm bell.

Let’s go through it step by step: the large bullish candle is a so-called exhaustion candle. The reason this candle is the largest of them all is that at this point, the most buyers finally are aware of this uptrend and so the most buyers are in the game. The imbalance between buyers and sellers is the largest here.
Next we see that at some price level, sellers start to push the price down, but don’t yet succeed (the bearish pin bar). There are still too much buyers that believe this will go higher, so it takes some more time. The next candle is what you could call an indecision candle candle, but I would call it the squeeze candle. Buyers are “squeezed” to keep their position and a lot will sell at a loss. At the same time, sellers see the price going down and are more convinced they are on the right side of the move. There is no victor yet and the battle continues until the last candle, where we see a strong move down and the sellers take control. The tide has turned and they will push the price further down.

What would you prefer to trade? The first or the second scenario?

I know what story gives me the most confidence on the direction of the price.

Clean price action and being able to tell a convincing story about what price is doing will help you in making better trading decisions. While it may take some time to be able to read charts like this, it is done purely by interpreting price action.

6. Find the major inflection points


Inflection points are areas that mark the beginning of a fundamentally different behaviour of the price. They are the big spikes indicating rejection of a certain price level, the turning points in the direction of the market. It’s characterised by a big concentration of buyers and/or sellers. It’s where the big moves happen. Inflection points often form a part of your support and resistance as well, and you will see that a lot of those inflection points regularly line up to be at the same price level.

These points (or areas) are important because there will be a lot of buyers and sellers looking at them. Lots of buyers and sellers will have orders close by that will trigger. Stop losses and take profits will be around these levels. It is therefore important that you keep an eye on these levels. But how do you find them?

Let’s look at an example:
Inflection points on price action

Basically, all areas where one of the following happens:
  • A major spike
  • A lot of increased activity
  • A major turning point in price direction

It takes some experience to know what the important inflection points on a chart are, but usually, the larger the spike or the stronger the move, the more important the inflection point will be. These points can line up with other inflection points to form support and resistance zones, which brings us to the next item.

7. Identify key support & resistance zones


Support and resistance (or S&R for short) are terms used to denote areas where price reverses at its lowest point (support) and highest point (resistance) on a chart. Often, these zones are “tested” multiple times as traders look for increased buyer and seller activity around these levels. It’s important to note that support and resistance are usually not thin lines, but rather zones. This example should make things clearer:
Suppor and resistance

The stretched out green rectangles represent support and resistance zones. Support indicates a lower level and resistance indicates an upper level. The green arrows show where price approached a resistance zone and (sometimes sharply) reversed. The red arrows show where price approached a support zone and reversed. Also note that sometimes the same zone can be resistance but then become support after price has broken through it (and the other way around).

Trending support & resistance

Support and resistance levels do not have to be horizontal either. Here is an example of support and resistance in an uptrend:
Support and resistance in an uptrend

As you can see, the lower and upper boundaries are here defined by a rising channel. At some moments, price protrudes the cannel but always comes back. Again, these boundaries are more like zones than specific lines (but it’s not easy in TradingView to draw rising zones 🙂 ).

Dynamic support & resistance

Finally, support and resistance can also be defined by dynamic lines, for example using moving averages or Bollinger bands boundaries (see, it’s not forbidden to use indicators – just know when they’re useful).

Here’s an example of dynamic resistance (note that price can still pierce through it sometimes, it’s not an exact science):Dynamic support and resistance

Support and resistance are of importance since they are often areas of increased buyer and seller activity. Price is more likely to react to such levels, giving us opportunities to enter the market.

Market reaction to support and resistance levels

I’ve found that horizontal support and resistance lines are usually more reliable than trend lines and dynamic S&R, but this depends on the situation and the amount of times a specific support or resistance level has been tested.

On the one hand, the more times a level of support & resistance has been tested, the more people will have eyes on that level so it will hold more easily. On the other hand, you have to consider the amount of buyers and sellers for a certain level. Every time a specific level has been tested, less buyers and sellers will be left to keep the level intact for the next time. This means that after a few tests, price might eventually break through it after all.

All of these things should be considered when defining your support and resistance. The more you do it, the better you will get at it.


8. The best price action is clean to the left


When you look at a price action setup on a chart, you will find that the best setups are usually clean to the left. What I mean by that is that ideally, the candles that precede the price action setup haven’t been around the same price levels that your price action setup is in.
Head and shoulders price action pattern

This chart shows a head and shoulders setup with a lot of “white” space to the left. For the past 30 or so candles, the market hasn’t touched the price levels the head and shoulders pattern is in. The reason professional traders prefer these kinds of charts is because when the price hasn’t been trading at the current levels for a while, it’s likely that there are less traders having pending orders on these levels, which in turn will make the price action pattern more meaningful.

9. Avoid price action in narrow ranges


Price action in narrow ranges is often less meaningful than when price makes a new high or low, or at least goes to a level that hasn’t been touched in a while. In narrow ranges, there is often too much buyer and seller activity going on to make some price action setup valid. This is similar to the previous point about having charts that are clean to the left of the price action, but expands on that.

A better approach could be to wait for a range breakout and look for price action setups there. A good way to measure if the price is in a narrow range is by using Bollinger bands. If the bands contract a lot, there is less and less volatility and price might be ranging. On the other hand, if the bands expand again, you will often see price trending or making bigger moves:
Ranging price action

Also know that the longer price is in a narrow range, the more likely it is that price will be trending afterwards.

10. Context is everything


Depending on where a price action setup occurs, you should interpret it differently. The same pin bar could be bullish or bearish, depending if they show up at the bottom of a downtrend or top of an uptrend, respectively. Not all patterns are also worth taking if they are not preceded by the right price action and happen at the levels that are in one way or the other of significance. This significance usually comes from confluent signals, which is the topic of secret 10.

This next chart shows exactly what I mean. There are multiple pin bars on the way up, but they’re not really meaningful as they don’t occur at levels that are significant. It’s clear that every single one of the pin bars lacks follow through and instead of a reversal, price keeps grinding higher. Keep in mind that the context of price action is everything.
Context of price action

Conclusion


Employing price action strategies is one of the most fundamental and powerful ways for a trader to become profitable. At the same time, it’s often not well understood and there are a quite a few misconceptions about it. In this guide, I’ve exposed some of the secrets to make price action work for you, providing you with examples to get the most out of your journey into the price action trading world.

It might take some time to get used to, but I believe price action trading is one of the best ways to understand markets. This doesn’t even only apply to forex, but a trader who understands price action can apply this to all kinds of financial markets such as futures, stocks, commodities and more. It’s about describing and understanding what’s at the core of every market.

If you want to know even more about how I trade using price action and want to learn a proven trading strategy, consider joining my Trade Advisor trading program. This price action program is made for traders who want to take their trading to the next level.

Good luck becoming a successful price action trader!

How To Trade Supply And Demand

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By far, one of the most common questions I get these days is how to trade supply and demand.
Even though the concept is essential to how free markets operate, it has gotten a lot more popular as the basis for trading strategies in recent years.
And it makes sense! Using supply and demand as a part of your trading arsenal can be quite effective and potentially very profitable. So let’s figure out how to use supply and demand in your trading.

What Is Supply And Demand?

Before we discuss anything else, we should define what supply and demand actually is. In short: demand is how many buyers there are in a given market and how much they are willing to buy an instrument. Supply is how many sellers there are in a market and how much they are willing to sell an instrument.

The Laws Of Supply And Demand

Imagine the following scenario: if the price of EURUSD increases, there will be more people willing to sell because it will make them more money, right? This is the law of supply: the higher the price, the higher the quantity that is supplied.
Now, imagine the scenario from the point of view of the buyers. Whenever something becomes cheaper, you will be more interested in buying, right? On the other hand, if the price increases, you’ll be less and less interested in getting it. This is the law of demand: the higher the price, the lower the quantity demanded.

Supply And Demand Dynamics

Given all of the above, we can draw a few conclusions. The first one is that when there is more demand (buyers) than there is supply (sellers), the price will go up.
Secondly, when there is more supply (sellers) than there is demand (buyers), the price will go down.
Finally, when there is as much supply as there is demand, the price will stay the same. In this case, we talk about supply and demand equilibrium.
With these dynamics in mind, we can view any chart as a balance or imbalance between supply and demand:
Let’s go over this example. At ①, we can see that there is a small area with Doji candles. The price doesn’t seem to move a lot because essentially, supply equals demand. This changes at ② because there is more supply than demand, driving the price sharply lower. At ③, we see some stability again where roughly, supply equals demand, forcing prices to stay the same.
At ④, we see that the price breaks out from this area again and starts rallying. There is more demand than supply here, meaning the buyers are in control. At ⑤, this dynamic changes again and we see a lot of sideways consolidation but eventually at ⑥, the sellers step in and move the price lower.
The price takes a breather at ⑦, meaning that there again is a supply-demand equilibrium, before pushing the price further down at ⑧. At this point, there is more supply than demand.

Supply And Demand Zones

Given what we discussed before, we can view any chart as a sequence of zones where there is supply and demand equilibrium with supply and demand imbalances in between.
Let’s focus on these zones in particular. Especially, the zones where the price is moving away from with a lot of momentum are interesting to us because whenever that happens, it’s a sign that the balance of supply and demand has shifted in a very substantial way.
Supply and demand zones are the origins of these price moves.
We can also use the following narrow definitions:
A supply zone is a horizontal price area at which a lot of sudden selling has occurred. This resulted in an imbalance between supply and demand, where supply greatly exceeded demand, pushing the price down.
A demand zone is a horizontal price area at which a lot of sudden buying has occurred. This resulted in an imbalance between supply and demand, where demand greatly exceeded supply, pushing the price up.
Here’s an example of supply and demand zones in action:
We can see how the supply zone shows a narrow consolidation (= supply and demand equilibrium) and all of a sudden, the price shoots out to the downside with a lot of momentum.
We can also see a demand zone with again, a narrow consolidation, from which a strong move up happens.
Here, we can see another example of an area of consolidation and the price moving strongly away from it with a lot of momentum:

Supply and Demand or Support and Resistance?

I often get asked what the difference is between supply and demand and support and resistance. In practice, you’ll often see that they are one and the same, but the way we determine them is different.
When thinking about support and resistance, you should imagine these zones as boundaries. They are areas on the chart where the price couldn’t break through and instead, bounced off from.
When thinking about supply and demand, your first thought should be on buyer and seller imbalances. In many occasions, the strongest buyer-seller imbalance is exactly at support and demand areas, but the driver of these forces is different.
Another difference is that supply and demand is often a leading indicator. While traditionally, support and resistance levels are only called as such after at least two tests, this is not the case with supply and demand. You only need a supply or demand zone to be created in order to plan a potential trade.
Eventually, what works best is if you can use both concepts together. One is not better than the other but both have benefits and drawbacks.

The 4 Supply And Demand Patterns

Before we get into learning how to draw our supply and demand zones, it’s useful to know that there are roughly 4 types of supply and demand, defined by how the price approaches the supply and demand zone and how it leaves the zone again.
These 4 types are:

1. Rally – Base – Drop

The first type of supply and demand pattern is called rally – base – drop. It happens when we see a rally to a certain zone, followed by a short consolidation and then a strong bearish move away from this zone again (the drop).
In this supply pattern, we’re looking for supply areas that we can see a strong bearish move away from. Here’s a chart example:

2. Rally – Base – Rally

The next supply and demand chart pattern is called rally – base – rally. This pattern happens when we see a rally to a certain zone, followed by a short consolidation which forms the base and then a further rally up again.
In this demand pattern, we’re looking for demand areas inside a trending market, from where we can see a strong bullish move from. Here’s an actual chart example:

3. Drop – Base – Rally

In the drop – base – rally pattern, we are looking for a bearish move (the drop) towards a demand zone where we see a short consolidation (the base), before the price turns around and rallies strong (the rally).
In this demand pattern, we’re looking for the low of the preceding downtrend, from which we can see a strong bullish move back up. Here’s a chart example:

4. Drop – Base – Drop

Finally, the drop – base – drop supply pattern shows the price in a downtrend, after which we can see a consolidation zone where the price takes a breather. After this, the price continues with a strong bearish move and further extends the downtrend.
In this supply pattern, we’re looking for supply areas inside of a bearish downtrend, from where the price continues down in a strong way. Here’s an actual chart example:

Drawing Supply And Demand Zones

Now that we know what supply and demand zones are and how the 4 different types of supply and demand zones can be identified, how exactly can we draw them? I use the following steps to identify supply and demand:

1. Find the Momentum Drive

In step one, we’re looking for a large price move. Long, successive candles in one direction work the best. Just open any chart and it shouldn’t be too difficult to find those. Here’s an example:
On this chart, we can see in four different occasions that the price made a strong move with successive candles in one direction.
Both the momentum (how fast is the price moving) and the absolute distance (for far did the price move before it stopped going in that direction) are relevant here. Of course, the best price moves show both momentum and a large absolute distance.

Trend Considerations

Another thing that plays a role is the overall trend direction. The best demand levels often happen after the price has been in a long downtrend, while the best supply levels often happen after the price has been in a long uptrend.
Why is that? The easiest analogy would be to think of the trend as a train in motion. The faster the train goes, the more force is necessary to make the train stop and reverse, right?
So if the price is in an uptrend, it will take much more sellers to make the price drop back down in the opposite direction. Conversely, when the price is in a downtrend, it will take much more buyers to make that downtrend stop and reverse. Let’s understand this with an example:
In the above chart, we can see a tight consolidation, after which the price sells off strongly. While this looks like any other good supply zone, we should also consider the overall trend direction:
See how this supply zone was created in a downtrend? Given that the overall trend was down, it would require fewer sellers to push the price lower because everyone was looking for shorts already.
When we look at the extension of this supply zone, we see how it didn’t hold on the way back up and instead, the price just moved through it without too many problems:

2. Find the Base of the Momentum Drive

After we have found the momentum drive, we should define our base. With the base, I mean the price area just before the price exploded in one direction. Often, you will see a small consolidation before this happens and it’s that consolidation that we are looking for. Especially, we’re trying to find the following:
  • the consolidated bearish price action before a bullish price move
  • the consolidated bullish price action before a bearish price move
Because it’s exactly this area that is responsible for the resulting move:
The base of a supply or demand zone is where the orders were placed that were responsible for moving the market in such a strong way.
Let’s apply this knowledge to our chart:
As you can see, I’ve marked the base for each of the strong moves we identified on the chart.

3. Refine the Base

Are we using the candle body for this or including the wicks as well? What are the upper and lower boundaries of a base?
The answer is it depends. While this is subjective, I have four things that I keep in mind while refining the base, that might help you too:

A) Size of the base

When the price action in the base is rather narrow, it often makes sense to include the wicks in this. Then again, when there’s a large spike, it might be ok to leave this out of the base.
Narrow base, no need to exclude wicks

B) Amount of consolidation at the base

When there is a tight consolidation period before the momentum drive, it makes sense to use the upper and lower boundaries of that consolidation as the base, regardless of whether this includes wicks or not. After all, that is where the orders were created before the momentum drive:

C) Confluence with other price action

In certain instances, we can line up certain supply and demand zone boundaries with previous support or resistance, swing highs or lows or other levels. This kind of confluence can be meaningful to find a better definition of your base:
In the above chart, we can see how the upper boundary of the demand zone can be made narrower since it lines up pretty nicely with previous support and a swing high spike. It ended up being pretty perfect demand area, as the price just briefly dipped in the area and then shot up again.

4. Extend to the right

Finally, we extend the base to the right and voila, we have our supply and demand levels! Here’s how that looks on the chart we were annotating earlier:
By now, you might also have noticed that something else happened: with almost every one of our supply or demand zones, the price eventually revisited that area and, for the second time, moved away in a strong fashion. Which brings us to the next point.

Supply And Demand Trading Patterns

The Supply And Demand Bounce

When you look at the above charts, can you see that some pattern seems to keep occurring after a strong move away from a supply and demand zone?
That’s right, after that strong momentum drive, we often see a pullback into that same supply or demand zone. Not only that, there’s a clear reaction as well, where the price seems to bounce from this level on the retest. This is the first trading strategy pattern you can use with supply and demand. Here’s another example on gold:
We can see how the price shoots up from a narrow consolidation on the left of the chart, creating a demand area. When the price eventually returns to this zone, we can see a quick dip into the demand area, after which the price moves up again.
Before we go on, I want to talk a bit about WHY this happens. After all, any supply and demand strategy can make much more sense if you don’t just understand how but also why. And this is where liquidity comes in.

Liquidity Patterns

In order to understand why supply and demand zones can work as the basis of a trading strategy, we need to look at how buyers and sellers behave around these zones. A lot of this comes down to finding liquidity.
Liquidity describes how easily an asset can be bought or sold.
When there is a lot of liquidity, we say that the orders can easily be absorbed by the markets. It means that there are many traders willing to take the other side of your order.
When there is little liquidity, it might be harder to get your orders filled. Because there might not be enough traders to take the other side of your trade at the price you want, you might get filled at a worse price than expected. The risk you assume is called market liquidity risk. Another common symptom of illiquid markets is that they have a bigger spread.
It also makes sense that the bigger your orders are, the more liquidity might be an issue. This is why some institutional traders use special techniques to get a good price for their order.

Order Slicing

Whenever institutional traders need to open a position, they do so with much larger size than the average retail trader. In fact, their positions are usually so big that if they were to simply enter at once, they would move the market considerably.
So what do they do? Many of them will employ something called order slicing, where they split up their single order into multiple parts and only execute those in the market once enough liquidity is available.
Institutional traders entering many orders at liquidity
This is creating the consolidation patterns before a momentum drive.
Whenever institutional traders need to enter a large buy order, they will do so part by part, waiting for the price to come down before pushing the next “slice” on the market. That creates patterns on the chart and the more you trade supply and demand, the more you will “see” the underlying dynamics of certain patterns that happen before supply and demand momentum drives.

Liquidity Accumulation

The second aspect is that institutional traders understand where liquidity is accumulating. As you might remember, we can see liquidity as orders on the opposite side of your trade. So where can they find that?
  • Above significant swing highs
  • Below significant swing lows
Let’s take the next chart as an example. The institutional trader is looking for enough liquidity to get a fill on his big order. He wants to go long but so he needs to find traders who want to sell their position to him.
Below the swing low, there will be lots of that liquidity: first, you will have the stop losses of buy orders, which will sell on the market once they’re hit. Additionally, there will also be traders who go short, again adding liquidity to the market.
This is why you will often first see a spike in the opposite direction at the origin of a strong price move. The Liquidity Spike is the pattern that gets created when large market participants need liquidity and move the market in order to get it.
Retail traders get trapped, their stops get hit and they will often talk about “stop hunting” while in fact, this is nothing more than normal market behavior.

Why the Supply And Demand Bounce Works

Using the previous chapter on liquidity, we understand what is creating both the consolidations and the momentum drives that creates supply and demand zones. But why is the price bouncing from our zones when returning to those same zones?

Reason 1: Institutional buying and selling

If there was an institutional trader (either a bank or hedge fund or anything else) who made the price move so strongly that it created a supply or demand zone, what really happened is that the liquidity around that price dried up.
This means that there wasn’t anyone left taking the other side of the position and this made the price move in a very strong way. However, it’s very likely that this institution also wanted to take a bigger position than it actually could. So what happens when the price returns to the level they were initially taking a position?
That’s right, they get in the market for a second time. In turn, this moves the market again, which is what drives the supply and demand bounce.

Reason 2: A Perfect Profit Taking Area

As we discussed earlier, the price always moves from one supply/demand balance to the next supply/demand balance. This means that for every trader that is waiting to enter at the supply or demand zone bounce, there’s another trader that is already in a position and dying to find a good spot to take profits.
So guess where they are looking to take profits? Exactly, the same supply and demand levels that we are looking at!

Reason 3: Cutting Losses on Higher Timeframe

Imagine for a second the following demand zone. We could see the price briefly dipping lower and then shooting up. Then on the return, we could see the price bouncing strongly back up again:
That was a 1H chart. Now look at the same instrument on the 8H charts. Imagine that at this demand zone, someone took a short on the 8H. Immediately, the price turns the wrong way and the trader is at a loss.
What happens is that whenever the price comes back to the entry, it gives the trader an opportunity to get out of what he thinks is a bad trade, for a break-even result. That was close!
Of course, when all these traders are covering shorts, it means that a lot of buy orders are flooding the market, again pushing the price back up.

The Myth of Pending Orders from Institutional Traders

I often read that the reason that supply and demand zones show a reaction on the retest is because of pending orders of institutional players. While it is true that institutional positioning drives price action around these levels, it simply doesn’t happen with pending orders.
The question you need to ask is: why would they want to do this instead of just using market orders? There is zero benefit in doing so and limit orders give the institutional traders at least two disadvantages:
1) it gives away their positioning for no good reason
Whenever a trader creates a pending order, this shows up in the order book. In most cases, those add liquidity to the market. It also gives an indication to other traders about how they are positioned, which is not necessary and doesn’t happen if they simply use a market order.
2) they don’t yet know what size could be absorbed by the market
Imagine that you have a really big order. As we discussed previously, the institutional traders will use specific techniques to make sure the price doesn’t move too much when these orders enter the market.
However, they don’t yet know how much liquidity will be available in the market around those zones so it doesn’t make sense to add pending orders yet. Any institutional trader will first need to observe the order book to see what size he could put on around these zones. Using pending orders would simply pose a risk that the market moves away too much.

Trading The Supply And Demand Bounce

So finally, once we’ve identifier a good trading opportunity, how do we enter these supply and demand bounces? There are roughly two ways and I’ll briefly go over them here.
But because this is an aspect of trading supply and demand that can be quite complex, I will keep some of the techniques I use for a future time 🙂 Needless to say that the way you trade these patterns can make the difference between profits and losses, even though supply and demand zones by themselves can already give you a potential edge.

1. Immediate Entry

The first way to trade supply and demand is to use an immediate entry, meaning that you just place an order in the supply or demand zone and whenever that order is filled, you’re in a trade.
The benefits of this is that it’s less likely you’ll miss a trade because you can create a pending order beforehand. The drawback is that you might risk that the level doesn’t hold at all and instead end up with a loss. however, if you have defined quality supply and demand zones, this will still work very well.

2. Delayed Price Action Entry

With this technique, you wait for price action confirmation. This confirmation can come in many ways but the general idea is that you want to see in some way that the supply or demand zone is acting as a barrier and blocks the price from going through it.
This entry technique can easily fill an article of its own but popular ways of finding “confirmation” are:
  • Engulfing bars
  • Inside bars
  • Fakeout spikes: bars with highs or lows beyond the zone but still closing inside the zone
  • Opposite direction breakouts
Here’s an example of how you can enter at the close of an inside bar at the supply zone:

Stops And Targets

Even though this can be done in a mechanical way, choosing stops and targets is probably the most subjective topic of trading supply and demand.
Part of the reason for this is that it also depends on who you are as a trader: do you like to have a high win-rate strategy with a low reward to risk ratio, or do you prefer a low win-rate strategy with a high reward to risk ratio?
This is a question that only you can answer, based on how many losses you can stomach. Needless to say is that a strategy that goes for 10R profits (what is R?) per trade, will have more losses on average than a strategy that goes for a 1:1 reward to risk.
That said, here is a good pointer:

Take into account volatility when determining stops

An indicator such as ATR can give you an insight into how volatile an instrument is and as such, can help you with determining how wide your stop loss should be. For example, we could choose to use a stop loss that is twice the 24-period ATR of the entry candle:

Conclusion

Supply and demand is at the core of what trading is all about, so it’s not surprising that it can form the basis of a powerful trading strategy.
The first step in trading supply and demand is understanding what it is, how it works and what drives price action around these zones. While only introductory, the aim of this article was to shed some light on this and I hope you found it helpful.
Supply and demand is easily so extensive that a book could be written about the topic. However, it’s also important to prevent misinformation from spreading so understanding the basics of supply and demand is where everything starts.
The next step for you should be to go out and look at charts. Identify the supply and demand areas and see how the price behaves around these areas. Observe, make notes and build your experience.
If you want me to write more about supply and demand and how to trade it, please leave me a comment on this article. Or if you simply enjoyed my article, feel free to let me know as well 😉

Good luck in the markets!

Note:


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