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Whether it’s the forex, bonds or stock market, the law of supply and demand governs market prices. In the foreign exchange market, one of the major driving forces behind the movement in each currency pair is supply and demand.
But what is it, and how can you begin applying it to your forex trading in real-time? Don’t worry, we answer these important questions below.
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At its core, supply and demand is a component of economic theory that’s combined with technical analysis that can be used in any of the financial markets.
Supply and demand state that if the supply of a commodity or currency, in this case, is low and the demand is high, it will create scarcity and push the price higher. Conversely, if supply is high and demand is low, it will generate an excess of the commodity or currency and lower the price.
In other words, the law of demand in FX states as the price of a currency increases, the demanded quantity of that currency will decrease. Similarly, the law of supply states that as a currency’s price increases, the quantity supplied will also increase.
As you can see, the law of supply and demand can be applied across all markets in the world that has tradable commodities. Now let’s put it into context for FX trading.
Let’s suppose you are trading a popular currency pair — the EUR/USD. If the supply for EUR/USD is low and demand is high, the pair will result in higher prices. If the supply for the pair is high and demand is low, it will ultimately drive prices lower.
The supply and demand of every tradable currency pair are determined by those directly involved in the forex markets. These participants include retail investors, speculators, hedge funds and central banks.
Like the equity markets, currency pairs will fluctuate greatly during times of uncertainty, fear and surprising macroeconomic events. For example, during times of fear, investors may reduce their exposure and begin piling into safe-haven currencies like the Japanese Yen.
You must also pay attention to central banks because their words will generate massive movements in one direction or another. For example, if the United States Federal Reserve Chairman comes out and decides that they will increase interest rates, it will likely increase demand for the US dollar.
Traders can use predetermined supply and demand levels combined with any news to get in or out of a trade profitably.
It is the macroeconomic events, technical analysis trading and the involvement of these participants that result in the constantly fluctuating movements in price. Essentially any trade that takes place in the financial markets contributes to the law of supply and demand.
When trading with a supply and demand strategy, you have to first understand what supply zones and demand zones are. Supply zones can be seen as a type of resistance and is a zone above the current market price where there is strong selling interest.
In supply zones, the sellers exceed the number of buyers and will drive the price lower as unfilled orders begin to get absorbed. A supply zone isn’t to be confused with quantity supplied.
The latter is the number of goods or services that are produced and sold at the current market price. This is different because the quantity supplied is determined by price fluctuation. In other words, supply is the supply curve and quantity supplied is the specific number at a specific price.
Demand zones are a type of support and are zones below the current market price where there is strong buying interest. Demand zones have buyers that exceed the number of sellers that push prices up as unfilled orders begin to get absorbed.
Like quantity supplied, demand isn’t to be confused with quantity demanded. The latter is a term to describe the total number of goods or services demanded by consumers over a period. Similar to the supply curve, the demand curve is the relationship between the quantity demanded and a specific price.
Essentially, the demand zone is the specific price points a buyer is able or willing to pay.
Before identifying supply and demand zones, you must first understand the most basic pattern on any currency pair’s chart — balance and imbalance.
Simply put, a balanced area on a chart shows sideways movement. This movement tells the trader or investor that there is an equal amount of buying and selling occurring.
An imbalanced area is when the currency pair begins to take a directional approach and tells the trader or investor that buyers or sellers are in control. Downward directional moves indicate sellers are in control and upward moves indicate buyers are in control.
When trading supply and demand, it’s vital that you can identify areas of balance and imbalance.
If you’re the type of trader that prefers visual technical analysis trading versus listening to squawk boxes for opportunities, there’s some good news for you. You can identify supply and demand imbalances by looking at the currency’s chart.
That means, if you have a predetermined bias for a currency pair’s direction, you can use the supply and demand levels to get in or get out and be a well-planned trader.
The first step is to identify the current market price and then look to the left to find any candles to indicate strong directional moves. These candles will typically have large bodies with little to no wicks.
Once you’ve identified the current market price and strong directional move candles, you’ll want to look for the origin of the move. This is where you’ll draw the base of your supply or demand zone.
Now that you understand how to identify the base, how can you apply it to your trading?
The first is to combine the zones with your knowledge of support and resistance. Oftentimes, supply and demand zones will appear near these levels.
It’s a great way to stay focused when it seems like you’re getting squeezed out. For example, let’s assume you have a demand zone just below a level of strong support. Depending on other variables, it suggests that it’s a strong place to buy into the currency pair.
However, how would you feel if the price starts to fall below the support level once you buy in? Well, now that you know there’s a demand zone just below, you can calmly focus on managing your trade while other players experience high-stress levels as if they were being squeezed out.
You can also use supply and demand zones to capture large reversal moves. It also happens to be one of the best ways to trade supply and demand exchange rates.
After identifying a strong zone, you simply wait for the price to come back and test the area. More often than not, if there’s a false breakout, you’ll see a high probability of a large reversal move.
Of course, you must also consider other factors that may affect the price at that specific time.
Lastly, you can always use these zones to help you manage your trade. If you’re trading from a demand to a supply zone, you can place your profit target ahead of the supply zone and your stop loss just outside the demand zone to avoid squeezes and to stay in the game.
Whether you’re brand new to forex trading or an experienced veteran, understanding supply and demand can contribute greatly to your successful trading career.
Once you fully comprehend the concepts, you begin to realize the true value once you begin identifying the areas on your trading platform to make profitable trades.
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