A few weeks ago I released an article detailing my method for trading retests at breakout levels. One of the main points I try to make in the article was the idea of drawing breakout levels using zones instead of lines. Something which I forgot to mention in the article was how you will tend to see a supply or demand zone form when the market breaches the breakout point.
Sometimes these zones will be inside the breakout zones but other times they will be found just above or below the zone. You may have seen how on occasion the market will spike through the breakout zone before turning and moving in the opposite direction, if you go down onto lower time-frames you’ll notice the market actually turns at the supply or demand zone which is found just outside the breakout zone rather than inside the breakout zone itself.
In the essence of trying to make trading easier and more profitable I’m going to show you how to incorporate supply or demand zones near the breakout point into your trading of the breakout zones themselves, this will allow you to draw the zones more accurately and give you a better idea of how big a stop-loss you may need to use when placing a trade as well as making trading retests more profitable.
Why Do Supply And Demand Zones Form Inside Breakout Zones ?
Supply and demand zones form in the market due to bank traders either placing trades or taking profits, the reason supply and demand zones manifest at breakout levels is because of bank traders taking profits.
Although the forex market is the biggest market in the world there are still liquidity constraints which means large institutions must use every opportunity they get to place trades – take profits and close trades. When there is a concentration of buy or sell orders in the market bank traders will use them to make some kind of trading decision no matter how small the overall orders may be.
Liquidity is created when there is a lot of people doing something at the same time, if a lot of traders are buying there is buy side liquidity available which means a trader can take an action which requires buy orders to be in the market such as take profits off a long trade or place short trades.
As explained in my breakout article if traders are anticipating a breakout they will place pending orders to buy/sell at recent highs or lows. When the market hits the breakout level their trades will executed and buy or sell orders will now be put into the market. These orders provide bank traders the opportunity to take profits off their trades without causing a large price change.
An additional point to make is how there will be number of traders placing market orders to buy/sell due to the movement into the breakout point itself, when it comes to the bank traders taking profits using the orders placed by the breakout traders they can only take a small amount of profit off their trades. If they take too much profit all of the orders coming into the market from the traders placing trades onto the movement into the breakout level will be consumed and the market will begin moving in the opposite direction, causing the bank traders open profit to decline.
If we look at the retest on the breakout above we can see there is a small pause as the market comes into contact with the breakout point. This tiny bit of buying is caused by bank traders taking profits off their sell trades using the pending orders to sell the breakout traders had placed at the breakout point.
The small pause is followed by a large move lower. At this point the bank traders have taken as much profit as possible off their trades using the pending orders to sell placed by the breakout traders. When the profit taking is complete the market drops, creating the supply zone the market returns a couple of hours later.
If you look closely the market doesn’t actually retest the point where the price broke out, it misses the level by around 4 pips, it does however hit the supply zone created by the profit taking.
If we had drawn a breakout zone using the method I gave you in my trading retests at breakout points article and waited for the market to enter the zone we wouldn’t have been entered into the trade because the market never touched the low of the breakout point. Had we drawn the breakout zone to incorporate the supply zone found just below we would have identified it as being part of the breakout zone and had an opportunity to go short as the market did hit the supply zone.
Here’s a more recent example……..
You can see I’ve marked the breakout zone using a rectangle as per the rules laid out in my trading retests article.
If you look closely you may notice how the candlestick which strikes the breakout zone ends up breaching the bottom of the zone. Looking on the lower time-frames will reveal the reason it’s turned below the zone is due to the demand zone found on the 5 minute chart.
You can see how the demand zone formed right at the edge of the breakout zone and the spike which broke the breakout zone tapped the demand zone before moving back in the direction of the breakout.
Adjusting The Breakout Zones
I think the best method of trading retests of breakout levels is to incorporate nearby supply or demand zones into our drawing of the breakout zone. We know from the previous images the market will sometimes go through the breakout zone but turn at a nearby supply or demand zone therefore if we make sure to include any supply or demand zones which are in close proximity to the breakout zone we’ll increase our chances of being entered into a successful trade.
To reconfigure the breakout zones to compensate for the supply and demand zones I think the first step is to draw the breakout zone.
For a full guide on how to draw breakout zones correctly check my article “How To Trade Retest Of Breakout Levels”
Once we have the breakout zone drawn the next step is to switch to a lower time-frame and locate the point where the market broke out.
On the 5 minute chart we can see how there is a small demand zone found just above the breakout zone, part of the demand is inside the breakout zone but there is a small section of it which is outside. Our job now is to bring the zone up a little to make sure the entire demand zone fits within the breakout zone.
Now the breakout zone includes the demand zone we can rest assured knowing our chance of the market truing when its inside the breakout zone are much better than if we didn’t have the demand zone incorporated.
If you have a situation where the supply or demand zone is far away from the breakout zone do not include it when redrawing the breakout zone, we only want to mark zones which are in close proximity to the breakout point if we start including supply and demand zones which are not close to the breakout zone we are increasing how much we must potentially risk on the breakout zone trade.
By incorporating nearby supply and demand zones into our drawing of the breakout zones we can increase the probability of the market turning inside the zone and get a better idea of how much to risk on a trade entry. It’s likely you will find supply or demand zone near breakout points just remember to only incorporate the zones which are near the breakout zone, if you begin including supply and demand zones which are over 10 pips away from the breakout zone you will increase how the size of your stop to the point where the risk rewards ratio of the trade will decrease significantly.