how-to-evalute-the-risk-to-reward-ratio

In this blog post, I will show you how to find supply and demand zones and how to trade them successfully.

To find supply and demand zones in the market, you only have to look at your charts, and try to spot successive large candles.

Let me show you an example with the EUR/CAD H4 chart below:

supply-and-demand-trading

Looking at the chart, we can notice the big down move made by sellers. 

 Here’s the point: if you are analyzing a chart and see such a move, you should stop and look at the beginning of the move, the candle size, and its strength.

Obviously, this is not a normal move; retail traders alone can’t move the market this way.

So, the move was likely made by a bank or financial institution.

It is, therefore, necessary for us to evaluate the strength of the zone.


As you can see, the beginning of the move is quick and strong, as the market didn’t spend time in the zone.

This piece of information shows us that the order was made by a financial institution; otherwise, it won’t be that swift.

The move was very strong. Look at the red candles; they are big and strong, indicating that a bank with huge trading volume must have been behind this price action move.

Notice that the zone is fresh, so it’s going to be tested for the first time. This makes the area more significant, as key price zones lose become more likely to be broken when they are tested a couple of times.

So, we know that we are looking at a supply zone. Don’t worry if you still have issues identifying the zone; with time and practice, you will easily spot supply and demand zones just from the first glance. 

Now, let’s draw the supply zone. See the chart again below:

how-to-draw-supply-zones

To draw a supply zone, you have to identify the basing candle first. In this example, the basing candle is a Doji.

Draw the distal line at the end of the upper shadow and the proximal line at the end of the lower shadow. This way, you get a perfect supply zone.

Now that we have established the supply zone, let’s evaluate the reward/risk ratio to see if the zone is worth trading or not.

Look at the chart below:

how-to-evalute-the-risk-to-reward-ratio

As you can see, the reward/risk ratio is attractive. If you don’t know how to calculate the reward/risk ratio, here’s the formula you can easily use to get the risk and the reward:

The risk = The entry value -The stop loss value

The reward: The profit target -The entry Value

In the chart example above, I highlighted the risk and the reward in different colors so that you can gauge what the trade potentially offers.

The trade offers approximately 1:7 reward/risk ratio. This means that you can potentially make seven times whatever amount of money risked in the trade if the market goes in your favor.

This type of trades shouldn’t be missed, because you don’t get to see such every single day; when you happen to see it, you should look to take maximum benefit from it.

Let’s suppose that you won this trade; it will give you so much confidence to trade without fear or stress since you will need to lose eight trades in a row before you lose money.

Interestingly, this is highly unlikely if you use the supply and demand strategies the right way.

This is the reason why I recommend you consider the reward/risk ratio before making a trade, as that is what will make a difference in your trading account.

Next, we have to make our top-down analysis to see whether what the price is doing on the higher timeframe is in our favor or not.

Since we trade on the H4 timeframe, the appropriate higher timeframe to do our analysis should be the weekly timeframe.

Let’s look at what is happening on the weekly chart. See below:

the-top-down-analysis

As you can see from the weekly chart above, the market is ranging, and a false breakout happened at the resistance level, indicating that the market is likely to go down.

However, before the support level that formed the lower boundary of the range, there is another support level that will probably stop the market from going down to that lower end of the range.

We don’t really know what is going to happen. But what we know is that there was a manipulation at the resistance that has shown us that the market will move down, and the price is going to test either of those support levels.

So, to be on the safe side, we will trade between the false breakout and the upper support level on the H4 timeframe.

To be honest with you, I will take the trade even if the market on the weekly is against the H4 timeframe. My reason is that the trade setup has all the odds to go in my favor. 

 

We do a top-down analysis to look at the bigger picture and see if there are some details that can help us confirm our entry or warn us to pay attention.

In this example, the false breakout at the resistance level is an indication that the market will go down at least to test the upper support level, so it confirms our trading idea on the H4 timeframe.

We can go short on the H4 timeframe if we have a candlestick pattern as a signal.

Now, we have all information we need: we have a powerful supply zone, with a good reward/risk ratio, and we have a false breakout at a resistance level on the weekly timeframe, which supports our decision.

So, all we need is a reversal candlestick pattern at the supply zone to signal us to place a sell order. 

 

Check out the chart below to see what happens next:

how-to-trade-supply-zones

As you can see from the H4 chart above, the market reached the supply zone and formed a nice inside bar candlestick pattern.

So, we place our trade once there is a downward breakout of the inside bar. Our stop loss would be above the upper end of the supply zone, while our profit target would be the next support level.

See the chart below:

trading-supply-zones-in-the-market

As you can see, we placed our trade after the breakout of the inside bar, and the stop loss above the supply zone, the profit target is the next support level.

Look at what happened after the formation of the inside bar: another bullish pin bar formed to indicate that the supply zone is likely to be broken and that the zone will fail.

Imagine you placed a trade and continued watching it to see what happens; how would you feel when you see that bullish pin bar formation? Of course, you will certainly be afraid, as you would think that the zone will fail, and you might either move your stop loss or close the trade. 

 

But look at what happens next! A big candle formed after an economic news release, taking the market down.

If you were trapped by your emotions, you would have missed the opportunity to make a lot of money from this trade.

This is why you should adopt the set and forget philosophy. That way, you will not let the market play on your nervousness; you will set the trade and forget it, and when you come back, you will find that the trade has gone in your favor and made you some money without fear or stress.

 

Conclusion 

In this post, I have shown you, with a clear example, how to spot a good supply zone and how to trade it successfully. You can learn other profitable trading strategies from our free Telegram channel where we interact and share more knowledge. I also give out 2 to 3 free live Forex signals per week on that channel.

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