Understanding Supply and Demand Key to Profitable Forex Trading

Zheng Wei Seow, Dealer | Contract for Differences

Zheng Wei graduated from RMIT university with a Bachelor’s Degree in Economics and Finance. His interest is in FX and trading with strategies  using a more hands-on approach as his trading style. There is always room for retail traders who love to grow on their own.

Have you ever wondered why your trading account continues to bleed despite your best efforts? Trading is inherently challenging, and retail traders struggle to achieve consistent success. This article offers a fresh perspective on how to interpret market movements and use them to your advantage. By understanding the role of Banks and Financial Institutions (BFIs) and learning to identify Supply and Demand Zones, you can refine your strategy and hopefully be more profitable.

As retail traders, we may believe we are in control of our trades. We analyse charts, apply strategies, and execute buy or sell orders, with the aim of capitalising on market movements. However, the truth is that retail traders are not the ones moving the market. In fact, they contribute only 9% to the stock market and 5.5% to the Forex (FX) market. [1] Our individual trades have minimal impact on price movements.

The real market movers are Banks and Financial Institutions (BFIs). These entities manage massive volumes of trade, often on behalf of large clients or to hedge their own portfolios. They are the primary source of market liquidity and create the significant price movements that we see on our charts. Retail traders are essentially reacting to their movements. And if we end up on the wrong side of the trade, our losses can be swift and severe.

In this article, we will focus on the Forex market, the largest financial market in the world. According to the Bank for International Settlements (BIS), the daily trading volume in the Forex market exceeds US$7.7 trillion. [3] This massive liquidity along with low transaction costs and the availability of leverage, makes Forex an attractive market for retail traders.

In Forex, currencies are traded in pairs, such as EUR/USD or GBP/JPY. The first currency in the pair is known as the base currency, and the second is the quote currency. For example, in the EUR/USD pair, the Euro (EUR) is the base currency, and the US Dollar (USD) is the quote currency. When you click “buy” or “sell,” you are speculating on the movement of one currency relative to the other.

For example:

• If you buy EUR/USD, you’re expecting the Euro to strengthen against the US Dollar.
• If you sell EUR/USD, you’re expecting the US Dollar to strengthen against the Euro.

As mentioned earlier, BFIs are the primary drivers of price movements in the Forex market. They execute large orders gradually at specific price levels, and this repeated activity creates Supply and Demand Zones, which often trigger sharp price reactions. Retail traders who can identify these zones and the associated trading patterns, stand a better chance of riding the institutional wave, instead of being wiped out.

Supply and Demand Zones are areas on the price chart where significant buying or selling pressure has previously caused the price to stall or reverse. They are typically characterised by sharp reversals when price revisits those areas. Here is how to identify them:

1. Supply Zones: These are areas where the price has reversed downward after a rally. They indicate an excess of supply, which creates selling pressure and price movement downward.
2. Demand Zones: These are areas where the price has reversed upward after a drop. They indicate an excess of demand, which creates buying pressure and price movement upwards.

For example, let us look at the USD/SGD pair on a 4-hour period. After a brief pause or consolidation, the price made a sharp move downward. By marking this area as a Supply Zone (Green box), we can anticipate that the price may reverse downward again if it retests this level.

Source: TradingView

Source: TradingView

Similarly, in a Demand Zone, we can expect the price to reverse upward if it retests the level.

Once you’ve identified Supply and Demand Zones, the next step is to look for trading patterns that indicate whether the price is likely to reverse or continue in the same direction.

1. Rally-Base-Drop (RBD): In this pattern, the price rallies upward, consolidates (forms a base), and then drops sharply. This indicates a potential reversal downward. As a trader, you will be waiting for price to retrace and retest the supply zone before opening a position.

Drop-Base-Rally

Source: Algo Trading & Investment

2. Drop-Base-Rally (DBR): In this pattern, the price drops, consolidates, and then rallies sharply. This indicates a potential reversal upward. As a trader, you would want to mark this area as a Demand Zone and anticipate a price reversal upwards if it retests the zone again.

Rally-Base-Drop

Source: Algo Trading & Investment

3. Drop-Base-Drop (DBD): In this pattern, the price drops, consolidates, and then continues to drop further. This indicates a continuation of the downtrend. As a trader, you would mark this area as a Supply Zone and anticipate price continuation downwards if it retests this level.

Drop-Base-Drop

Source: Algo Trading & Investment

4. Rally-Base-Rally (RBR): In this pattern, the price rallies, consolidates, and then continues to rally further. This indicates a continuation of the uptrend. Traders can mark the consolidation point as a demand zone if the price retraces and test that price level again.

Rally-Base-Rally

Source: Algo Trading & Investment

One of the most reliable candlestick patterns for confirming Supply and Demand Zones is the Pin Bar. A Pin Bar is characterised by a long wick and a small body, indicating rejection of a certain price level.

Source: DotnetTutorials

Here’s how to use Pin Bars in your trading strategy:

• Bullish Pin Bar: Indicates rejection of lower prices and a potential reversal upward.
• Bearish Pin Bar: Indicates rejection of higher prices and a potential reversal downward.

For example, in the GBP/JPY pair, we can see a Bullish Pin Bar forming in a Demand Zone. This confirms that the price is likely to reverse upward from this level.

Source: TradingView

No trading strategy is complete without proper risk management. Even the best setups can fail. That is why robust risk management is non-negotiable. Here are two common methods to manage your risk:

1. Percentage Risk: Risk only 1%-3% of your account balance per trade. For example, if your account balance is $10,000, you should risk no more than $100-$300 per trade.
2. Fixed Dollar Amount: Determine a fixed dollar amount to risk per trade (e.g., $200) then calculate your position size based on your stop-loss level.For example, if you are willing to risk $100 per trade and your stop-loss is 20 pips, you can calculate your position size with this formula:
   Position Size = (Dollar Risk ÷ Stop-Loss in Pips) × Pip Value

This helps you to avoid overtrading and risking too much of your account on a single trade.

Trading is a skill that requires continuous learning, practice, and discipline. By understanding the role of Banks and Financial Institutions (BFIs) and learning to identify Supply and Demand Zones, you can refine your strategy and improve your chances of success. Remember, the key to long-term profitability is not just having a good strategy but also managing your risk effectively. Take the time to practice these concepts, back test your strategies, and stay patient. With persistence and the right approach, you can turn your trading account into a profitable one.

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