Defining and Trading Around Important Support and Resistance

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Defining and Trading Around Important Support and Resistance

Support and resistance are words that get tossed around a lot, and traders and analysts will mark up their charts with all sorts of supposed support and resistance levels, but most of these levels really have minimal impact on the price. Understanding what an important support or resistance level is can help you isolate better trading opportunities and avoid likely losers.

Minor (or inaccurate) Support and Resistance

When most people mention support or resistance they are simply looking at a recent high or low on the chart. But do these highs and lows give any indication that those prices will provide support or resistance in the future?

In Figure 1, an indicator has been added to the chart which simply marks short-term high and low points with red (resistance) and blue (support) line.

Figure 1. EUR/USD 1 Minute Chart

The first thing to realize is support and resistance levels, especially these minor ones based on short-term highs and lows, are likely to be broken relatively easily. During an uptrend we expect the recent highs to be broken as the price moves to a higher high (definition of uptrend). And during a downtrend we expect the price to move below recent lows (definition of downtrend).

Therefore, while these minor highs and lows may provide some trend confirmation, they do little to actually stop price from advancing or declining.

Important Support and Resistance

Certain levels are more likely to stop the price from rallying or falling though–these are called important support and resistance levels and are really the only support and resistance I pay attention to.

While we expect these levels to be broke at some point as well, they deserve more respect.

I show these levels respect by:

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  • not taking a short position when the price is right above important support
  • not taking a long position when the price is right below important resistance
  • possibly going long on a very strong bounce off support
  • possibly going short on a very strong bounce off resistance

Those are a few of the trading guidelines (not absolute rules) I follow when trading around an important support or resistance level.

Important support and resistance levels are price regions which changed the direction of the market in a significant way.

In figure 2 regions that have causes reversals are marked on the chart with white boxes.

Figure 2. EURUSD 5 Minute Chart with Important Support and Resistance

As soon as the price significantly reverses direction the area is marked with a rectangle, such as those in figure 2. They are then extended out to the right until broken (could be a very long or very short time). Learning to utilize this method will take time and practice.

Moving from left to right on the chart, the price is moving higher and then witnesses a significant drop. Since this area caused a significant reversal it is marked on the chart (1). While there is not guarantee this area will stop the price from rising in the future, it is quite possible the price will struggle to get through the area.

After the initial sharp drop the price bounces aggressively, drops again and then bounces aggressively. This indicates there is an important support level there (2). The price then proceeds to rally, and then stalls, just below the support level. It makes several attempts before finally breaking through.

Before breaking through 1 the price breaks lower and then rallies aggressively. While this level causes a smaller reversal than 1 and 2 it is marked because the direction did change (short-term lower low) and it does prove important toward the left on the chart as the price bounces off it.

4 marks where an aggressive rally died and reversed. In the future, when the price eventually approaches this area, it should be treated with respect.

If a level is drawn and then the price moves aggressively through it (“breaking ” it), it can be deleted as it is no longer relevant. Resistance marked “1” was broken by an aggressive move higher; once that occurs it can be deleted.

These types of levels deserve respect, and thus I choose to alter my trading slightly when around them. Isolating a few important areas like this is much cleaner, and provides more relevant information, than drawing tons of unimportant high lows on the chart.

Where you draw the original area may not be the exact support or resistance area. For example, the area marked “1” encompassed the original high, but this level could be moved slightly lower (or drawn a bit bigger) to also contain where the price met resistance in that vicinity later on. Resistance and support are always areas which may need to be adjusted slightly over time.

How big you draw the areas will depend on volatility and the timeframe you are trading on. They should be small enough that they only focus on one particular region, but big enough that they will alert you of potential false breakouts or when the price is within proximity to the important area.

Play with this concept, potentially in conjunction with some of the trading guidelines, to come up with a personal plan for how you will define and handle these situations.

Support and Resistance Basics

The concepts of support and resistance are undoubtedly two of the most highly discussed attributes of technical analysis. Part of analyzing chart patterns, these terms are used by traders to refer to price levels on charts that tend to act as barriers, preventing the price of an asset from getting pushed in a certain direction. At first, the explanation and idea behind identifying these levels seem easy, but as you’ll find out, support and resistance can come in various forms, and the concept is more difficult to master than it first appears.

Trading With Support And Resistance

Key Takeaways

  • Technical analysts use support and resistance levels to identify price points on a chart where the probabilities favor a pause or reversal of a prevailing trend.
  • Support occurs where a downtrend is expected to pause due to a concentration of demand.
  • Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply.
  • Market psychology plays a major role as traders and investors remember the past and react to changing conditions to anticipate future market movement.
  • Support and resistance areas can be identified on charts using trendlines and moving averages.

Support and Resistance Defined

Support is a price level where a downtrend can be expected to pause due to a concentration of demand or buying interest. As the price of assets or securities drops, demand for the shares increases, thus forming the support line.   Meanwhile, resistance zones arise due to selling interest when prices have increased.

Once an area or “zone” of support or resistance has been identified, those price levels can serve as potential entry or exit points because, as a price reaches a point of support or resistance, it will do one of two things—bounce back away from the support or resistance level, or violate the price level and continue in its direction—until it hits the next support or resistance level.

The timing of some trades is based on the belief that support and resistance zones will not be broken. Whether the price is halted by the support or resistance level, or it breaks through, traders can “bet” on the direction and can quickly determine if they are correct. If the price moves in the wrong direction, the position can be closed at a small loss. If the price moves in the right direction, however, the move may be substantial.

The Basics

Most experienced traders can share stories about how certain price levels tend to prevent traders from pushing the price of an underlying asset in a certain direction. For example, assume that Jim was holding a position in stock between March and November and that he was expecting the value of the shares to increase.

Let’s imagine that Jim notices that the price fails to get above $39 several times over several months, even though it has gotten very close to moving above that level. In this case, traders would call the price level near $39 a level of resistance. As you can see from the chart below, resistance levels are also regarded as a ceiling because these price levels represent areas where a rally runs out of gas.

Support levels are on the other side of the coin. Support refers to prices on a chart that tend to act as a floor by preventing the price of an asset from being pushed downward. As you can see from the chart below, the ability to identify a level of support can also coincide with a buying opportunity because this is generally the area where market participants see value and start to push prices higher again.

Trendlines

The examples above show a constant level prevents an asset’s price from moving higher or lower. This static barrier is one of the most popular forms of support/resistance, but the price of financial assets generally trends upward or downward, so it is not uncommon to see these price barriers change over time. This is why the concepts of trending and trendlines are important when learning about support and resistance.

When the market is trending to the upside, resistance levels are formed as the price action slows and starts to move back toward the trendline. This occurs as a result of profit-taking or near-term uncertainty for a particular issue or sector. The resulting price action undergoes a “plateau” effect, or a slight drop-off in stock price, creating a short-term top.

Many traders will pay close attention to the price of a security as it falls toward the broader support of the trendline because, historically, this has been an area that has prevented the price of the asset from moving substantially lower. For example, as you can see from the Newmont Mining Corp (NEM) chart below, a trendline can provide support for an asset for several years. In this case, notice how the trendline propped up the price of Newmont’s shares for an extended period of time.

On the other hand, when the market is trending to the downside, traders will watch for a series of declining peaks and will attempt to connect these peaks together with a trendline. When the price approaches the trendline, most traders will watch for the asset to encounter selling pressure and may consider entering a short position because this is an area that has pushed the price downward in the past.

The support/resistance of an identified level, whether discovered with a trendline or through any other method, is deemed to be stronger the more times that the price has historically been unable to move beyond it. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit points because these areas often represent the prices that are the most influential to an asset’s direction. Most traders are confident at these levels in the underlying value of the asset, so the volume generally increases more than usual, making it much more difficult for traders to continue driving the price higher or lower.

Unlike the rational economic actors portrayed by financial models, real human traders and investors are emotional, make cognitive errors, and fall back on heuristics or shortcuts. If people were rational, support and resistance levels wouldn’t work in practice!

Round Numbers

Another common characteristic of support/resistance is that an asset’s price may have a difficult time moving beyond a round number, such as $50 or $100 per share. Most inexperienced traders tend to buy or sell assets when the price is at a whole number because they are more likely to feel that a stock is fairly valued at such levels. Most target prices or stop orders set by either retail investors or large investment banks are placed at round price levels rather than at prices such as $50.06. Because so many orders are placed at the same level, these round numbers tend to act as strong price barriers. If all the clients of an investment bank put in sell orders at a suggested target of, for example, $55, it would take an extreme number of purchases to absorb these sales and, therefore, a level of resistance would be created.

Moving Averages

Most technical traders incorporate the power of various technical indicators, such as moving averages, to aid in predicting future short-term momentum, but these traders never fully realize the ability these tools have for identifying levels of support and resistance. As you can see from the chart below, a moving average is a constantly changing line that smooths out past price data while also allowing the trader to identify support and resistance. Notice how the price of the asset finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down.

Traders can use moving averages in a variety of ways, such as to anticipate moves to the upside when price lines cross above a key moving average, or to exit trades when the price drops below a moving average. Regardless of how the moving average is used, it often creates “automatic” support and resistance levels. Most traders will experiment with different time periods in their moving averages so that they can find the one that works best for this specific task.

Other Indicators

In technical analysis, many indicators have been developed to identify barriers to future price action. These indicators seem complicated at first, and it often takes practice and experience to use them effectively. Regardless of an indicator’s complexity, however, the interpretation of the identified barrier should be consistent to those achieved through simpler methods.

The “golden ratio” used in the Fibonacci sequence, and also observed repeatedly in nature and social structure.

For example, the Fibonacci retracement tool is a favorite among many short-term traders because it clearly identifies levels of potential support/resistance. The reasoning behind how this indicator calculates the various levels of support and resistance is beyond the scope of this article, but notice in Figure 5 how the identified levels (dotted lines) are barriers to the short-term direction of the price.

Measuring the Significance of Zones

Remember how we used the terms “floor” for support and “ceiling” for resistance? Continuing the house analogy, the security can be viewed as a rubber ball that bounces in a room will hit the floor (support) and then rebound off the ceiling (resistance). A ball that continues to bounce between the floor and the ceiling is similar to a trading instrument that is experiencing price consolidation between support and resistance zones.

Now imagine that the ball, in mid-flight, changes to a bowling ball. This extra force, if applied on the way up, will push the ball through the resistance level; on the way down, it will push the ball through the support level. Either way, extra force, or enthusiasm from either the bulls or bears, is needed to break through the support or resistance.

A previous support level will sometimes become a resistance level when the price attempts to move back up, and conversely, a resistance level will become a support level as the price temporarily falls back.

Price charts allow traders and investors to visually identify areas of support and resistance, and they give clues regarding the significance of these price levels. More specifically, they look at:

Number of Touches

The more times the price tests a support or resistance area, the more significant the level becomes. When prices keep bouncing off a support or resistance level, more buyers and sellers notice and will base trading decisions on these levels.

Preceding Price Move

Support and resistance zones are likely to be more significant when they are preceded by steep advances or declines. For example, a fast, steep advance or uptrend will be met with more competition and enthusiasm and may be halted by a more significant resistance level than a slow, steady advance. A slow advance may not attract as much attention. This is a good example of how market psychology drives technical indicators.

Volume at Certain Price Levels

The more buying and selling that has occurred at a particular price level, the stronger the support or resistance level is likely to be. This is because traders and investors remember these price levels and are apt to use them again. When strong activity occurs on high volume and the price drops, a lot of selling will likely occur when price returns to that level, since people are far more comfortable closing out a trade at the breakeven point rather than at a loss.

Support and resistance zones become more significant if the levels have been tested regularly over an extended period of time.

The Bottom Line

Support and resistance levels are one of the key concepts used by technical analysts and form the basis of a wide variety of technical analysis tools. The basics of support and resistance consist of a support level, which can be thought of as the floor under trading prices, and a resistance level, which can be thought of as the ceiling. Prices fall and test the support level, which will either “hold,” and the price will bounce back up, or the support level will be violated, and the price will drop through the support and likely continue lower to the next support level.

While spotting support and resistance levels on a chart is relatively straightforward, some investors dismiss them entirely because the levels are based on past price moves, offering no real information about what will happen in the future.

Determining future levels of support can drastically improve the returns of a short-term investing strategy because it gives traders an accurate picture of what price levels should prop up the price of a given security in the event of a correction. Conversely, foreseeing a level of resistance can be advantageous because this is a price level that could potentially harm a long position, signifying an area where investors have a high willingness to sell the security. As mentioned above, there are several different methods to choose when looking to identify support/resistance, but regardless of the method, the interpretation remains the same—it prevents the price of an underlying asset from moving in a certain direction.

How to Trade Support and Resistance

Now that you know the basics, it’s time to apply these basic but extremely useful technical tools in your trading.

Because here at BabyPips.com we want to make things easy to understand, we have divided how to trade support and resistance levels into two simple ideas: the Bounce and the Break.

The Bounce

As the name suggests, one method of trading support and resistance levels is right after the bounce.

Many retail forex traders make the error of setting their orders directly on support and resistance levels and then just waiting for their trade to materialize.

Sure, this may work at times but this kind of trading method assumes that a support or resistance level will hold without price actually getting there yet.

When playing the bounce, we want to tilt the odds in our favor and find some sort of confirmation that the support or resistance will hold.

For example, instead of simply buying right off the bat, we want to wait for it to bounce first before entering.

If you’ve been looking to go short, you want to wait for it bounce off resistance before entering.

By doing this, you avoid those moments where price moves fast and break through support and resistance levels. From experience, catching a falling knife when trading forex can get really bloody!

The Break

In a perfect world, support and resistance levels would hold forever, McDonald’s would be healthy, and we’d all have jetpacks.

The fact of the matter is that these levels break… often.

So, it’s not enough to just play bounces. You should also know what to do whenever support and resistance levels give way!

There are two ways to play breaks in forex trading: the aggressive way or the conservative way.

The Aggressive Way

The simplest way to play breakouts is to buy or sell whenever price passes convincingly through a support or resistance zone.

The key word here is convincing because we only want to enter when price passes through a significant support or resistance level with ease.

We want the support or resistance area to act as if it just received a Chuck Norris karate chop: We want it to wilt over in pain as price breaks right through it.

The Conservative Way

Imagine this hypothetical situation: you decided to go long EUR/USD hoping it would rise after bouncing from a support level.

A. Accept defeat, get the heck out, and liquidate your position?

B. Hold on to your trade and hope price rises up again?

If your choice is the second one, then you will easily understand this type of forex trading method.

Remember, whenever you close out a position, you take the opposite side of the trade.

Closing your EUR/USD long trade at or near breakeven means you will have to short the EUR/USD by the same amount.

This phenomenon is the main reason why broken support levels become resistance whenever they break.

As you would’ve guessed, taking advantage of this phenomenon is all about being patient.

Instead of entering right on the break, wait for price to make a “pullback” to the broken support or resistance level and enter after the price bounces.

A few words of caution… IN FOREX, THIS DOES NOT HAPPEN ALL THE TIME. “RETESTS” OF BROKEN SUPPORT AND RESISTANCE LEVELS DO NOT HAPPEN ALL THE TIME. THERE WILL BE TIMES THAT PRICE WILL JUST MOVE IN ONE DIRECTION AND LEAVE YOU BEHIND. BECAUSE OF THIS, ALWAYS USE STOP LOSS ORDERS AND NEVER EVER HOLD ON TO A TRADE JUST BECAUSE OF HOPE.

Whoops, sorry about that folks, the caps lock key got stuck.

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