Support and resistance from lesson 2 are lines. Supply and demand zones are areas, drawn where price left quickly because one side's orders swamped the other's. Fair value gaps mark the same kind of imbalance in just three candles, and both show you where to pay attention when price comes back.
What you will learn
- How to draw a demand zone and a supply zone from the base and the move away from it
- How to mark a fair value gap from three candles
- Which zones are worth watching and which to leave off your chart
- How to plan an entry, stop and target once price reacts at a zone
Draw a demand or supply zone
A demand zone is an area where buyers overwhelmed sellers: price paused in a tight base for a few candles, then rallied hard. A supply zone is the reverse, a base followed by a sharp drop. The idea behind both is that orders left unfilled at that price may still be waiting, so price may react when it returns.
- Find a strong move away: two or more large candles in one direction, ideally breaking a recent swing high or low.
- Find the base just before it, usually one to four small-bodied candles where price paused.
- For a demand zone, draw from the top of the base's candle bodies down to the bottom of its deepest wick. For a supply zone, draw from the bottom of the bodies up to the top of the tallest wick.
Say GBP/USD pauses for three 1-hour candles. Their bodies top out at 1.2715 and the deepest wick reaches 1.2700. Then price rallies 90 pips to 1.2805 in four candles. Your demand zone runs from 1.2700 to 1.2715, 15 pips deep.
If a zone comes out wider than the move that left it, the base was too loose. Redraw it on a lower timeframe, or skip it.
Judge which zones are worth watching
Most charts give you more zones than you can watch. Four questions cut the list down.
- How hard did price leave? A move of several large candles shows a bigger imbalance than a slow drift.
- Is the zone fresh? A zone price has not come back to yet still holds its waiting orders, and each return uses some of them up, so a zone tested twice is weaker than a fresh one.
- Does it sit with the trend? A demand zone below price in an uptrend is worth more than one in a downtrend, using the read from trends and trendlines.
- Is there room? Measure from the zone to the nearest opposite zone. If that distance is less than twice your stop, the trade has little reward in it.
Mark a fair value gap
A fair value gap (FVG) is a three-candle pattern where the middle candle moves so fast that the first and third candles do not overlap. In a bullish gap, candle one's high is below candle three's low, and in a bearish gap, candle one's low is above candle three's high. The space between them is a range that price crossed only once, during candle two.
On a EUR/USD 15-minute chart:
- Candle one has a high of 1.0842.
- Candle two is a large bullish candle from 1.0838 to 1.0871.
- Candle three has a low of 1.0856.
The gap runs from 1.0842 up to 1.0856, which is 14 pips. Some traders also mark the middle of the gap, here 1.0849, as the level they expect price to reach on a return.
Price often comes back into a gap, but not always, and a gap can be filled partly or completely. If a candle closes below 1.0842, the bottom of this bullish gap, it is no longer a support area. For a full walk-through, see the fair value gaps and imbalance lesson.
Plan the trade from the zone
Before you commit, wait for price to react inside the zone. Back to GBP/USD: two days later price drops into the demand zone at 1.2700 to 1.2715. On the 15-minute chart a bullish engulfing candle, from candlestick patterns, closes at 1.2720.
- Enter at 1.2720.
- Place the stop 15 pips below the zone at 1.2685, which is 35 pips of risk.
- Target 1.2805, the high of the rally that created the zone, which is 85 pips away.
- The reward is 85 ÷ 35, or about 2.4 times the risk.
The alternative is a limit order resting at the top of the zone. You get a better price and you never miss a fast reaction, but you also buy every zone that fails, with no reaction to filter them out. A middle path is to use limit orders only for fresh zones that line up with the higher-timeframe trend.
When a fair value gap sits inside or right next to a demand zone, the two describe the same imbalance, so that overlap is the part of the zone to watch most closely.
Check your understanding
Candle one's low is 1.3050 and candle three's high is 1.3032, with a large bearish candle between them. What have you found?
A bearish fair value gap from 1.3032 up to 1.3050, which is 18 pips deep.
A demand zone has already held price twice. Is it as strong as when it formed?
Usually not. Each return uses up some of the orders resting there, so treat it as weaker than a fresh zone.
Price reaches your demand zone but keeps falling with large bearish candles. What do you do?
Stay out. The zone was an area of interest, and price has given no bullish reaction. If a candle closes below the zone's lower edge, take it off your chart.
Key points
- Demand zones come from a base followed by a strong rally, and supply zones from a base followed by a strong drop.
- A fair value gap is the space between candle one and candle three when they do not overlap.
- Fresh zones that sit with the trend and leave room to the next opposite zone are the ones worth watching.
- Wait for price to react at the zone, then set the stop beyond it and the target at the next opposite zone.
Next lesson: Line up a higher-timeframe trend with a lower-timeframe entry
All trading is simulated. Rewards are based on performance and are not guaranteed.