Forex trading is based on the economic concept of supply and demand. A market with high demand is likely to appreciate in value, while a high-supplied market will likely depreciate in value.
But what happens when the market’s supply and demand become too sparse? It creates a market imbalance.
An imbalance forex market signifies that it’s experiencing a significant sparsity between the buyers (demand) and sellers (supply) of currency pairs. While this sounds bad, it actually presents profitable opportunities to traders who can identify these market imbalances.
In this article, you’ll better understand market imbalance and its significance in forex trading. Read on to learn how you can profit from this market movement.
Basics of Supply and Demand in Forex
Analyzing, predicting, and timing the market movement is the primary way to profit from forex trading. One effective way to do such is by looking at the prevailing supply and demand in the market. Why?
Supply and demand are the forces that drive the changes in market price.
Remember,
- In high-demand markets, value increases due to the scarcity of supply.
- In high-supply markets, value decreases due to a lack of demand and liquidity.
When there’s a significant buying pressure on the certain asset, its market movement will trend upward because of the increase in demand. Meanwhile, a financial asset experiencing a selling pressure is likely to have a market that’s trending downward.
But why does this happen?
Well, it’s mainly due to the market sentiment. The sentiments are the current attitude, mood, and confidence of financial investors towards a particular currency pair, or any financial asset.
In the case of market imbalance, a high-demand or high-supply market signals the potential market movement. A high-demand market causes buying frenzy, which results to an influx of buyers wanting to capitalize on the price increase. Meanwhile, a high-supply market signals a downward market movement because investors are offloading their holdings.
The Concept of Imbalance
Literally speaking, imbalance signifies a lack of proportion between two or more variables.
In the forex market, the concept of imbalance follows the conventional definition of the word; but with focus on the number of buy and sell orders for a particular currency pair.
Did you know?
Market imbalance is also referred to as the supply and demand imbalance. Essentially, it’s because the increased in supply or demand of the particular market creates price inefficiencies.
When the number of buyers is significantly greater than sellers, the market goes in favor of the buyers; basically, appreciating in value. The same goes when sellers outnumber the buyers, the market leans towards the sellers’ favors.
In your trading chart, an imbalance is represented as the gap between the wicks of the neighboring candlesticks. When the candlestick of the same color registered another candle with short to no shadow, the imbalance in forex occurred in that gap or price level.
Most of the time, financial institutions, whales, and market makers cause these imbalances in forex. They essentially place big chunks of trades to manipulate the market movement.
However, other market fundamentals may also cause the market to be imbalanced. We’ll discuss this in the latter part of this article.
But here’s what you should remember. When only retail traders trade currencies, their movement tends to trade in range or at support and resistance levels.
Usually, institutions and whales cause supply and demand imbalances
The common reason as to why an imbalance in forex occurred is because of the financial institutions, big investors, and whales’ participation in the particular currency pair market. They do this to either keep their trade position on the winning side or to intervene in the relative strength of foreign currencies in a pair.
This accumulation of trade positions results in an imbalanced forex market and creates significant price movements.
For example, the Bank of Japan tries to intervene in the AUD/JPY market. They create significant selling pressure to strengthen its JPY against the AUD by selling currencies of Australia. This way, the JPY market strengthens against the AUD.
Effective Way to Identify Imbalance in Forex
Trading the market imbalances is among the profitable trading strategies as it gives you a reference regarding the potential market movement.
Here are effective ways to identify potential imbalances. Use this indicator to make informed trading decisions and predict the potential market direction of your trade.
Using Support and Resistance Levels
In forex trading, the support and resistance level refers to the market level where the particular asset’s price is having difficulty breaking through. A resistance level tells you the price area in which the market can’t trade higher, while the price area where the asset can’t trade lower is the support level.
And this technical analysis indicator is a great help in identifying potential imbalances.
Assume that the EUR/USD market is approaching its resistance level, but you’ve noticed that there are more buyers than sellers. This is a signal for a bullish imbalance. With this reference, you can assume that the market may break through its resistance level because of increased buying pressure.
Looking for Marubozu Candlesticks
Another effective indicator for identifying potential imbalances is the prevailing candlestick pattern called Marubozu.
When the market forms this pattern, it creates a candle with a long body, with little-to-no shadows or wicks.
Remember, the only way to identify market imbalances is to look at your chart’s candlestick and look for a gap between the shadows of the neighboring candles.
If you’re unfamiliar, you can use several candlestick patterns when analyzing the potential market movement.
These patterns not only indicate a market imbalance but also give you an idea about the prevailing market sentiment. These patterns can be used for effective and profitable forex trading.
Looking at Volume
Volume indicates the total number of assets that are being bought and sold over a specific period. In other words, it tells you the ratio of buyers and sellers in the market.
Again, the core concept of a market imbalance is the disparity between the number of buyers and sellers. This indicator can tell if an imbalance is occurring or about to occur in the market.
Using volume indicators with support and resistance levels can draw a more accurate analysis.
How Imbalances Affect the Forex Market?
The imbalance between the buy or sell orders has a huge impact on the market, as it directly dictates the supply and demand for foreign currencies.
Here are three market aspects that greatly affect the market imbalance.
Market Sentiment
Market sentiment, such as the confidence of investors in the market, is greatly affected by the market imbalance.
Remember that in forex trading, acting upon the potential market direction is essential to keep your trade safe and even profitable in the forex market.
By looking at an imbalance in the forex market, you can tell whether the currency pair is under high buying or selling pressure. This bolsters the confidence of the market in either entering or exiting its holdings.
Imagine this:
Assume you’re holding a long EUR/USD at 1.2300. One moment, you’ve noticed a sign of market imbalance at 1.2450, signaling a strong selling pressure at the price area.
With this reference, you set a sell limit order below 1.2450. The market imbalance formed, and it depreciated; but because of your limit order, you keep your trade safe from the market reversal.
Central Bank Intervention
The decision to intervene by the central bank can also be made due to the significant imbalance between the foreign currencies in the pair.
Central banks may buy or sell their currency in the forex market to address the imbalances. For example, a central bank might buy its own currency using foreign reserves to battle excessive currency depreciation.
Aside from actually participating in the forex market, a central bank can correct imbalances by jawboning. Jawboning is an economic term referring to the verbal intervention of a certain central bank official.
By jawboning, the central bank can talk up or talk down its currency by enunciating the readiness to intervene (actually buying or selling currencies) or by highlighting concerns about the currency value.
Changing Exchange Rate
An imbalance in a particular market of a currency pair often results to a change of a currency’s exchange rate.
Central banks can adjust interest rates to influence currency values. Raising rates can attract foreign capital, appreciating the currency, while lowering rates can have the opposite effect.
An imbalance in the forex market is also influential in the essence of trade imbalance. When a country has a trade deficit, it imports more than it exports.
This increases the supply of its currency in the forex market as it sells its currency to buy foreign currencies for payment. This excess supply can lead to depreciation of the currency.
Economic Impact
Forex trading has immense implications to the global economy; and interestingly, the growth of different economies can influence the forex market. Just like how seesaw works!
Strong economic growth attracts foreign investment, increasing demand for the country’s currency and causing it to appreciate. Conversely, slower growth or recession can lead to currency depreciation as investors seek more stable or higher-growth markets.
Types of Imbalance Forex Market
Forex imbalances are key drivers of market movements. It carries the discrepancies between the supply and demand on a particular forex market.
Remember, with this market situation, you can expect significant price movements as the market seeks equilibrium.
Bullish Imbalance
A bullish imbalance occurs when buyers in the market significantly outnumbers sellers. This imbalance typically leads to upward pressure on the currency’s price.
This type of market imbalance is greatly characterized by increased buy orders. As more market participants place buy orders, the security value is likely to appreciate, initiating a bulling market.
Bearish Imbalance
A bearish imbalance represents a market situation in which the number of sellers significantly exceeds the number of buyers. This typically results in downward pressure on currency prices.
Increased sell orders are the main indicator of this imbalance. During this market imbalance, more investors sell their holdings due to several factors, including negative economic news and outlook, low interest rates, or political instability.
Both bullish and bearish imbalances impact the market, specifically its volatility, breakout potential, and the formation of sustainable transformation.
Use Imbalance for Effective Forex Trading
As I’ve said, trading market imbalances is among the most profitable strategies for forex trading.
Here’s how you can leverage imbalances through different trading strategies like news trading, trading breakouts, and scalping.
News Trading
In forex trading, your ability to trade the news releases is essential because the economic releases are known to be a primary market mover.
News trading involves making trades based on the anticipated impact of economic news releases and events.
Here’s how to use imbalances effectively in news trading:
- Stay Informed: Keep an eye on the economic calendar for upcoming news releases such as GDP reports, employment data, central bank announcements, and other economic indicators that can cause significant market movements.
- Pre-Positioning: If you expect a news release to create a market imbalance, you might position your trades before the announcement. For example, if strong job numbers are expected in the US, you should go long on the USD.
- React Quickly: Post-announcement, the market can move rapidly. Reacting quickly to unexpected news can capitalize on sharp movements. For instance, the associated currency might spike if a central bank unexpectedly raises interest rates.
Remember, the forex market during the news release is extremely volatile. Use appropriate risk management techniques like setting stop-loss orders to protect against adverse movements.
Trading Breakouts
Trading breakouts involve entering a trade when the price breaks out of a defined support or resistance level, indicating a potential market imbalance.
Here’s what you should do when you trade breakouts during market imbalances:
- Identify Key Levels: Determine key support and resistance levels on the chart. These levels are often where significant price movements occur once broken.
- Volume Confirmation: Confirm breakouts with increased trading volume, as this indicates stronger conviction behind the move and reduces the likelihood of a false breakout.
- Enter on the Breakout: Enter a trade when the price breaks above resistance (for a long position) or below support (for a short position). This signals a potential imbalance where supply and demand have shifted.
Just like during news releases, a breakout market can be risky if you’re not equipped with techniques for risk mitigation. Use stop-loss orders just below the breakout point (for long positions) or just above (for short positions) to protect against false breakouts.
Also, you should consider placing take-profit levels based on the expected breakout magnitude.
Scalping
In the forex market, a scalper is an investor who seeks to take advantage of short-term or small price movements. Scalping strictly involves placing a huge number of trades in the market, often exploiting minute supply and demand imbalances.
- Fast Execution: Scalping requires quick execution to capitalize on small price changes. Use a broker with low spreads and fast execution speeds.
- Technical Indicators: Utilize technical indicators like moving averages, Bollinger Bands, and stochastic oscillators to identify entry and exit points. Look for moments when the market is slightly out of balance.
- High Frequency: Place numerous trades over short periods, aiming for small gains each time. This strategy benefits from frequent, small imbalances rather than larger, less frequent ones.
Since scalping involves frequent trading, strict risk management is crucial. Use tight stop-loss orders and avoid over-leveraging. The goal is to accumulate small profits consistently while minimizing losses.
