What is support and resistance?
As a trader and market analyst, you will notice that there are certain price barriers that prevent market participants from pushing the price above or below those levels. These levels are known as support and resistance levels or Floors and ceilings respectively.
A resistance line is a price level that a certain asset struggles to break in an upward direction. This is evidence of traders perceiving a tradable instrument as expensive or over-bought.
A support line, the opposite of the resistance line, is a price level that an asset’s price struggles to break in a downward motion; as the tradable instrument is seen as oversold.
Static support and resistance levels:
These support and resistance levels do not move as time passes and are represented by a horizontal line.
It is important to note that when drawing the static support and resistance levels that those levels are drawn using a horizontal line.
When drawing static support and resistance levels we turn to historical data to show us levels where a price has on several occasions struggled to break.
By drawing the horizontal line from the peak or trough to the next peak or trough respectively, you will avoid market fake outs. (A fake out happens when a price breaks through a support or resistance line, momentarily, only to return to its previous price channel). A fake out should be analysed in detail as they can signal increasing price pressure to a certain direction. Fundamental events or data can be analysed to determine if the fake out will result in a subsequent push to break a support or resistance line.
What I like to do is use candlestick charts and then draw my support and resistance levels from the Highs or lows of the wicks. This helps to avoid fakeouts. I would also recommend using bar charts but drawing support and resistance levels on a line chart can be dangerous because it doesn’t show how high or low the price has moved in 1 tick.
Trend lines are best used as indicators of momentum, i.e. a period of a diagonal upward or downward ranging price. The steeper the trend line, the shorter the duration of the trend. As a trader, steep trend lines will offer high profits but only for a short duration. You may have to remain seated as a trend change is inevitable and could happen in a flash. Some trading platforms have trend lines by angle where you can get a feel of how steep the trend line is. There are three kinds of trends: uptrend, downtrend and sideways (ranging) trend.
A trend line can be drawn using the two most recent highs and lows of the trending price. A third point can be used to confirm the trend. Trend lines should be drawn as is and should not be forced to fit a predetermined trend.
When the price of a security changes within a given range: the trend could be upward, downward or even flat. The key point to know about these trend channels is that the two trend lines form a trend channel; the top line (resistance line) and the bottom line (the support line). The more a trend line is tested the more it holds, i.e. the trend channel becomes stronger and it is more probable that the channel will be observed for a longer period.
Example of 2 trend lines creating a trend channel (downward trend)
So how will a trend line help you? Even though the price movement of a currency pair might swing up and down, the trend channel serves as a reassuring tool to remind you or show you the bigger picture; the trend.
A popular saying amongst traders: ‘The trend is your friend.’
Avoid abnormal moves (Outliers, movements greater than 3 standard deviations from the mean). If you spot a candlestick with an abnormally long wick then ignore it as this could lead to false support and resistance zones.
Support and resistance levels need to be viewed as a general zone and not just one point in price however if you do draw the support and resistance lines from the wick of the candlestick you will dramatically reduce the size of the zone.
Note: it is important to know that when a price breaks a resistance zone then that line becomes the new support line.
A while back as a young and upcoming trader, I was fortunate enough to have a mentor to show me the “ropes”. He always said that I need to imagine that there are holes in the ceiling and the floor. He then began to bounce a tennis ball and told me that if the ball hit the ceiling then there was a chance that it could go through one of the holes and then bounce on the next story until it either went through the next ceiling or fell through a hole in the floor and would come back to the previous story.
In the same way, this is how a price reacts to support and resistance levels. If the price breaks a resistance line moving in an upward direction then that price level becomes the new floor/support zone. The same applies in the opposite direction i.e. price breaks through the support level.
Note: The more times a support and resistance level has been tested the stronger that zone is. Example a support and resistance zone that has been tested several times is much stronger than one that has only been tested once.
Dynamic support and resistance:
The term dynamic refers to an ever changing support and resistance level that changes with the price action over time.
A good example of a dynamic support and resistance indicator would be a moving average. By plotting the 200-day moving average onto a chart we can use it as a tool to identify dynamic and ever changing support and resistance levels.
Example: in the chart above we can see that the 200-day moving average acted as a level of support and resistance throughout the timeframe, this is indicated by the white circles on the blue 200-day moving average.
Note: more will be covered on the 200-day moving average later on in this section.
Price level support and resistance lines:
Support and resistance lines also form around areas in price that are close to round numbers. Example: 1.0000 or 1.1100 as opposed to 1.1156 or 1.0235. This is because people naturally like round numbers and when placing a trade they will often place it around a round number.
The resistance line lies on the price 1.0000
A useful tip is to always place your stop losses in odd number groups, excluding the number 5. For example: instead of setting your stop loss at 1.2455 set it at 1.2459.
Also, when using multiple time frames on charting software, it is important to note that the longer time frames’ support and resistance zones carry more weight than say the 5 min chart. In a similar fashion; the more zero’s the price has – the more weight it carries.
Example: 1.0000 has a lot more weight than 1.1200.
Note that Rounded Price support and resistance levels are static.
Why is this information useful?
As a trader, our job is to look for possible entry and exit points and then take trades based on that logic. A very popular method for intraday traders is to use support and resistance levels to determine possible entry and exit strategies. It also helps the trader to identify how much risk they are taking based on a particular trade.
After identifying support and resistance levels; traders will often look for certain chart patterns to confirm their trade ideas. An example would be a price pattern defining a trend’s formation or a reversal pattern such as the ‘Double Top” or “Head and Shoulders” patterns.
(We will go in depth into these chart patterns in a later section)
NOTE: Support and resistance levels help us to manage risk. A popular method is to set stop losses below or above support and resistance levels, respectively.
IMPORTANT Risk Management: Do not set your stop losses on a support and resistance zone as the chances of the stop loss getting hit is high. Often, prices will retrace to a support and resistance level and then bounce off only to continue in the opposite direction.
Support and resistance levels can provide you with a statistical edge.
Why do these support and resistance levels form?
Support and resistance levels form for many different reasons but the two primary reasons are:
- Price has reached a psychological point where market participants perceive the price as either overbought or oversold.
- Support and resistance levels are zones where a lot of buyers and sellers enter the market. There is a lot of entry and exit orders around these levels (traders taking profit etc), therefore volumes will often increase as the price comes closer to these zones.
We just covered the most basic method of determining these levels. Support and resistance price points/levels come in various forms. This subject branches off into more advanced sections that will not be covered in this chapter. They include topics like fractal geometry and market psychology.
Popular tools for finding support and resistance levels:
- Trend lines
- Fibonacci Zones
- Pivot points