SMC TRADING PART 5 – Supply and demand trading strategy based on structure – Trading Systems – 10 April 2023

II. Fundamental Knowledge

• Structural foundation: 
• Estimating direction based on structure 
• No matter how varied the form, structure breaks it all 
• The role of structure in trading
• Supply and demand foundation: 
• Supply and demand trading strategy based on structure

Supply and demand trading strategy based on structure  

Directional expectations from structural breakthroughs

Price trends are driven by the push of funds and profit-taking behavior, with pushing behavior forming the main uptrend and profit-taking behavior forming adjustments. A series of continuous pushes and profits, in retrospect, are trends.

Going with the trend means breaking through the high/low point structure of prices and forming higher highs/lower lows; reversal means breaking through the high/low point structure of prices and forming lower highs/higher lows.

For example, in an uptrend, the high points tend to be continuously broken, and the low points also continuously rise; when the trend reverses downwards, the low points will be continuously broken, and the high points will also continuously decline.

Structural breakthroughs on a larger time frame will bring directional expectations. This direction does not have certainty, only a slightly higher probability advantage. Skilled traders can combine multiple methods to enhance probability, but it can never reach 100%.

The significance of supply and demand relationships

Supply and demand relationships are the first of Wyckoff’s three laws and are closely related to fund behavior. From a macro perspective, supply and demand relationships determine the direction of market price changes; from a micro perspective, supply and demand relationships also determine the entry and exit positions of traders.

When supply and demand are balanced, the market is in a consolidation phase; when supply and demand are imbalanced, the market moves in a directional manner.

• If supply is greater than demand, the market price will fall. 
• If demand is greater than supply, the market price will rise.

Following the trend or following big money?

What makes the price candlestick move up and down? Is it the collective efforts of countless individual traders?

The larger the market volume, the more capital is needed to move prices. For example, in the forex market, only large financial institutions such as banks, investment banks, and funds can significantly change prices, and they play a decisive role in the market trend.

Unlike individual traders, financial institutions trade with huge amounts of capital and often face the problem of insufficient liquidity[1]. Even if large orders are split into smaller ones, they will still cause significant changes in the market price.

For example, if an institution wants to complete one buy order, there must be an equivalent amount of sell orders in the market. If there are not enough sell orders at the current price, demand will far exceed supply, and the price will rise to match the sell orders until they are completely filled. This is reflected in the chart as a sudden appearance of a large bullish candlestick (or a series of bullish candlesticks).

It is impossible for the remaining orders split by institutions to continue to be completed through pending orders. In addition, based on cost considerations, if the current price is far from the accumulation zone, institutions will manipulate prices to return to the vicinity of the accumulation zone by closing profitable positions. If the accumulation zone of the institution can be identified in advance, this is an excellent trading opportunity.

The supply and demand trading method is a method of identifying the intentions of major funds, and following the footsteps of big money may be more reliable than following the trend.

How to Identify Institution Accumulation Zones

After big money enters the market, there will be a clear characteristic, which appears as a large bullish or bearish candlestick on the chart, or a series of bullish or bearish candlesticks. If viewed through order flow software or volume distribution charts, you will find that within the range of these candlesticks, there are almost only buy orders or sell orders.

These strongly imbalanced candlesticks are somewhat similar to gap openings. Because they are caused by insufficient liquidity, these large candlesticks can also be called liquidity gaps.

Except for market fluctuations caused by news, any large candlestick has the potential to be a trace left by institutional accumulation. Because institutions are not a union and still eat smaller fish, institutions in the Asian, European, and American sessions also attack each other, especially during the European and American sessions, which often lead to reversals. Only under the condition of unified fundamentals, can smooth trend movements occur simultaneously in the Asian, European, and American sessions.

One of the methods to determine whether it is institutional accumulation is to confirm the behavior of institutional accumulation if the price returns to the vicinity of the starting point of the large candlestick shortly after.

However, it is important to note that not all large candlesticks in any position can be used. A limiting condition must be added, which is to break through the high/low points of the structure or range. When a large candlestick that may be an institutional accumulation zone appears, it is necessary to see if the price can break through the previous structure or range next. If it cannot break through, it means that the effort has no result, and there is likely a divergence of volume and price.

If a large candlestick appears and breaks through the previous structure’s high/low point, then we can expect this institutional accumulation zone to be effective and place a limit order here.

Structural Types of Institutional Accumulation Zones

The name “institutional accumulation zone” is a bit long, and if you already understand its meaning, you can also call it a supply-demand zone or decision zone. The term “decision zone” is based on the breakout pullback system and “supply-demand zone” seems more appropriate in this article. Supply-demand zones can be divided into two categories based on their structure: reversal and continuation[2].

Reversal structures:

• RBD – Rally-Base-Drop (from uptrend to downtrend) 
• DBR – Drop-Base-Rally (from downtrend to uptrend)

Continuation structures:

• DBD – Drop-Base-Drop (downtrend continuation) 
• RBR – Rally-Base-Rally (uptrend continuation)

Structure-based Supply-Demand Trading Model

• The red block in the figure is the stop loss range for the short limit order, and the red line is the entry point for the short position; the blue block is the stop loss range for the long limit order, and the blue line is the entry point for the long position. 

• Point a is the first target of the limit short order at point B, where some profits will be locked by reducing the position, and point C is the second entry point for the short position. 

• Point b is the entry point for the contrarian long position, which will be fully closed at point B (also the area for short selling, but not a market order, but a pre-set limit short order).

Two Momentum Types in Supply-Demand Zones

In the supply-demand trading model, both points A and C are reversal structures, but the momentum of institutional accumulation is different.

1. Engulfing Pattern: Common supply-demand zones belong to engulfing candlestick combinations, and the stronger the momentum, the longer the body of the engulfing candlestick.
2. Multi-Candlestick Reversal Pattern: This type of supply-demand zone has slightly weaker momentum than the first type. Typically, the first reversal candlestick is a piercing pattern, and two or more consecutive candlesticks are needed to break through the low point of the base candlestick (RBD) or the high point of the base candlestick (DBR).