One of the things supply and demand traders are interested in is knowing when the zones may be about to fail. Whilst there is no sure shot way of knowing for sure whether a zone is going to fail or not there are some warning signs you can look out for which signal the market may be about to break the supply or demand zone your trading, we’re going to take a look at three things I’ve found over the years which you can use to spot an impending supply or demand zone failure.
Engulfing Candle In The Opposite Direction
Engulfing candles mark the beginning and end of every movement in the market, this makes them perfect for determining when a supply or demand zone may be about to break. When we place trades based on supply and demand zones we typically use engulfing candles inside the zone as an entry signal into our trades. The hint the market gives you about a zone beginning to break also comes from a seeing an engulf inside the zone only……
…….the engulfing candle itself is the opposite to which direction you want the market to move in.
If you were trading a supply zone and you see a bullish engulfing candle form inside the zone.
If you were trading a demand zone and you see a bearish engulfing candle form inside the zone.
The engulfing candle will form either when the market is still inside the zone or after the market has made a small move out of the zone.
Here we have a supply zone on the 1 hour chart of USD/JPY
On the first reaction to the supply zone we see a bearish pin bar. The market fails to move lower after the pin and we see a large bullish engulfing candle move back into the zone. It would be at this point upon seeing the bullish engulfing that you should be thinking about closing your short trade.
When the bullish engulfing candle appears it’s giving you a signal the move lower from supply has failed and the chances of the market now moving higher past the zone have increased dramatically.
Here’s an example of an engulf which appears after the market has made a small move lower.
There’s a chance this could have been a profitable trade if you had managed to get out quick enough but for the people who got into the supply trade expecting a large move lower the bullish engulfing candle signaled the end of the down-move.
When you see a large engulfing candle engulf another large candle it means the retail traders who brought or sold on the candle which is being engulfed will have to watch as their trades go from being at a profit to being at a loss. As the market begins to engulf the candle they have brought or sold on ( in the example above they sold ) their loss will become bigger and bigger and eventually it will reach a point where they do not want to lose any more money so they close their losing short trade.
Closing their trade has the effect of pushing the market further against the other trades who have sold on the candle being engulfed, making their loss bigger and in turn forcing them to close their trade too.
This bring us on to an important rule when we see an engulfing candle against the direction of a supply or demand zone.
The more traders who have gone short ( or long ) on the candle which is being engulfed the higher the chance the market has of breaking the supply or demand zone.
In the example above we know a large number of traders went short as the market had fallen slightly before being engulfed higher. Additionally the bearish candle which ended up being engulfed was a bearish large range candle which we know from Oanda’s open positions graph make a large number of traders go short.
Therefore we know there will be a significant amount of traders closing losing short trades when the market engulfs the candle, which means the market is going to move a large distance as these traders liquidate their positions.
If you see an engulfing candle appear within the zone or soon after the market makes a move out of the zone then the larger the candlestick which is being engulfed the higher chance the market has of breaking the supply or demand zone.
Zone Exit Failure
Another “hint” you can watch out for to see if a supply or demand zone is about to fail is the zone exit failure.
The exit failure is when the market returns to a supply or demand zone and then proceeds to make a move in the direction you anticipated before failing and turning into a pin bar.
The reason this happens is due to bank traders coming into the market and placing trades on the move out of the zone.
In this instance we had a situation where the market spiked the supply zone creating a bearish pin bar and then proceed to drop lower.
The drop lower fails and the result is a bullish pin bar.
There are a few reason why this supply failed.
The first is the move down beforehand. When the market falls creating the supply zone it had already been moving down for a pretty long time. A large number of traders would be going short as they expect the market to continue falling lower. If the market was to move up from here all of the traders who were entered short would be put at a loss and the large institutions can make alot of money forcing the traders to close their trades.
When the market runs up into the supply zone and causes a bearish pin bar to form, price action traders begin selling as this is a candlestick pattern they usually trade and all the requirements they need to see in order to think this as a high probability setup are present i.e trend is down – pin bar has a large wick – body of the pin closes into the previous candle.
All of these things confirm to the trader the bearish pin is a good sell setup, therefore they sell expecting the market to fall lower.
Two candles later the market makes a sudden drop, the sudden drop makes reactive traders go short. They will look at the fact the market is in a downtrend and see the sudden drop as confirmation of the market wanting to move down.
The banks know these traders have gone short as they understand how retail traders make market related decisions.
They have been buying at the bottom of the last drop which created the supply zone, they want the market to move higher as it would make a large amount of trades lose money which ends up going in their pockets. The sudden drop which makes reactive traders go short is an opportunity for them to get more buy trades placed into the market, when they place these buy trades all the sell orders from the reactive traders will be consumed and the market will begin moving higher.
Their buying is what creates the wick on the bullish pin bar.
What other entity would buy when the market makes a sudden move lower ?
It’s not going to be retail traders because we know they only buy and sell in the direction the market is currently moving in.
So it has to be traders working for large institutions.
Take a look at the run the market went on after this exit failure. The only way for the market to be able to move such a large distance is if professional trader were buying when the market was at the lows when we saw the exit failure.
Wait For The Next Candle
Usually when you see an exit failure, just seeing the pin bar form on its own is not enough for you to close your supply or demand zone trade.
In my article on trading pin bars in supply and demand zones, I talk about how seeing a pin bar form in a zone is not enough for you to take a trade and how you can get a better sense for whether the pin bar is going to work or not by waiting for the next candle after the pin to form.
A pin bar on its own is not a definite sign the supply or demand zone is going to fail, by waiting to see if the next candle is bullish or bearish you have more certainty as to whether the zone is going to fail or not.
Here’s an example…….
Look at the demand zone above, if you had placed a trade in this zone when you see the bearish pin you may be considering closing the position. If you did end up closing the trade you would be disappointed because this ended up turning out to be a pretty successful trade.
On the other hand if you had waited to see what the next candlestick after the bearish pin turned out to be then its likely you would have kept the position open as the next candle was bullish, suggesting to you the market is still going to move higher.
The important thing to remember when seeing an exit failure is you must see the move fail soon after the market hits the supply or demand zone.
You must see the market produce a pin bar within the first 1 – 4 candles after the market touches the zone. If the market sits in the zone for a long time and you see a pin form then it’s not considered an exit failure and it could mean a whole variety of other things are taking place behind the scenes.
Trading Zones Late Into Trending Movements
The last sign we are going to look at isn’t something which occurs when the market is inside a supply or demand zone ?
Instead it’s where the supply and demand zone itself is located in regards to the trend.
I touched on this a little bit when I was explaining the zone exit failure.
Trending movements are like a scale of probability.
In a downtrend the best place to be short from is at the top of the trend, getting an entry around here means you have the maximum profit potential. If you go short after the market has been going down for a long time then the amount of profit you can potentially make decreases due to everyone now placing trades in the same direction.
Of course it’s very difficulty to get short at the of a downtrend because the market will still look like it’s in an uptrend
What traders fail to realize is the location of where your taking trades when the market is in a trend has a dramatic effect on whether you trade will end up working out profitability or not. If you sell after a large move down then the likely hood of your trade begin successful is low as your placing a trade at the point where pro traders who caused the down-move are likely to take profits.
This concept translates to all other trading strategies too.
If the market has been going up for a long time and there has not been a significant pullback or consolidation then the chance of the market continuing to move in the same direction decrease the higher it moves. So if you see a supply or demand zone form late into a trending move its unlikely the zone is going to result in you having a successful trade due to the probability of the market making a move against the trend increasing.
I want to draw your attention to the down-move marked between the two vertical lines.
When the market is falling and you see this supply zone form you would probably assume its a good trade. I mean, the trend is obviously down, the market is making lower lows and lower highs, overall there’s a high chance you’d place a pending order to sell trade when the market hits this zone.
The problem with the move down is it has not had any significant pullback or consolidation take place, therefore at some point it will not be able to continue moving lower. It has to move higher in order to make the traders who are selling late into the down move lose money, by attempting to trade the supply zone marked above you also trading late so there’s a high chance you will also lose money.
One of the best ways of looking at the market is it’s a environment where people ( or traders in our case ) must keep on getting confused as to what is actually taking place.
When the market keeps doing the same thing for a long duration of time people assume its going to continue doing the same thing for the foreseeable future.
This is one of the primary rules behind trend trading. The longer the trend, the more likely it is to continue in the same direction. In the supply zone example above the market made a swing down and no pullback took place, which makes trader believe the market is certain to continue lower.
Therefore when the market begins pulling back against the down move its likely for the zone to be broken due to fact the market needs to move a far enough distance counter to the down-move in order to make as many traders as possible believe the market is now certain to go up.
The rule you can use to keep yourself out of low probability supply and demand zones is this….
If you see a supply or demand zone form after the market has been moving in the same direction for a long time and during the time it has been moving in the same direction no major pullback or consolidation has took place then its best if you refrain from placing a trade at the zone.
A major consolidation is when the market consolidates for over a day, a major pullback is when the market pull-back counter to the move your observing. In the previous image you can see the market stopped moving lower for around six hours before it dropped creating the supply zone. This is not what I call a major pullback as no move higher took place against the down-move. If the market had made a move up back to the swing lows which were broken when the market fell then I would consider that a major pullback as it made a large number of short traders lose money.
The first two warning signs I gave you at the beginning of this article are not occurrence you will see everyday. The exit failure is far less common than seeing an engulfing candle in the opposite direction. Even though these are not common things it is still really important to have knowledge on them so you’re prepared for when they do eventually occur.
Seeing zones form late into trending movements is something you can see happening frequently in the markets.
It’s a concept which translates to all time-frames in the market, whether it be the 5 minute chart the 1 hour chart or the weekly chart, the idea remains the same. If the market makes a trending move without a consolidation or pullback taking place during the move then the trend cannot continue in the same direction.