How do Currency Prices Behave at Support and Resistance Levels, and Why do they Sometimes Bounce ?
The principles of Support and Resistance trading levels are without a doubt some of the most debated features of technical analysis. Those terms are used, as part of the analysis of chart trends to show price ranges on charts that appear to serve as barriers, stopping an asset’s price from being moved in a particular direction.
At first glance, the meaning and theory behind these levels sound easy to recognise but, as you will find out, support and resistance come in various ways, and the principle is more difficult to understand than it seems at first, including how they affect price.
- Technical analysts use the level of support and resistance to note price points on a chart where the odds favour a delay or reversal of a prevailing trend.
- Support happens when a downtrend is predicted to stop due to demand concentration.
- Resistance exists when an uptrend, due to supply concentration, is expected to stop momentarily.
- Customer psychology plays an important part in informing traders and buyers of the past and responding to changing circumstances to predict potential price changes.
- Trendlines and moving averages can be used to classify support and opposition zones on maps.
What are Support and Resistance ?
Support is a price point where a pause is expected on the downtrend due to a concentration of buying interest or demand. If the commodity or stock price declines, demand for the shares rises, thereby creating the line of support. Conversely, as price increases, resistance zones emerge as a result of selling interest.
If an area or “zone” of support or resistance is established, such price thresholds will act as possible entry or exit points as, when a price approaches a point of support or resistance, it can do one of two things – bounce back from the level of support or resistance, or break the level of price and continue in its movement direction – until it meets the next level of support or resistance.
Some trades are placed based on the expectation that areas of support and resistance will not be disrupted. If the price is stopped by the support or resistance level, or it breaks through, traders may “bid” in the direction and easily decide if they are correct. If the price is going in the wrong direction, you can close the position at a slight loss. However, if the price moves in the right direction, the move may be huge.
Price Movement Along Support and Resistance Levels
Many seasoned traders will tell tales about how some price levels appear to discourage traders from driving the price of an underlying commodity in a particular direction.
For example, suppose Jim held a position in stock between March and November and expected the value of the shares to increase. Then, imagine Jim seeing the price struggling to get above $39 several times over several months, even though it’s come really close to getting beyond that point. In this scenario, traders will consider the price level around $39 a point of resistance. As shown in the map below, resistance levels are also viewed as a ceiling, since these price ranges reflect places where a rally loses steam.
Support levels are the other side of the coin. Support is the prices on a chart that appear to serve as a floor by avoiding downward movement of an asset’s price. From the chart below, the ability to recognise a support point can also correlate with an incentive to buy as this is usually the region where market players find value and start driving up rates again.
The above examples demonstrate the existence of a constant level that prevents the price of an asset from moving higher or lower. This static barrier is one of the most prevalent types of support/resistance, but financial asset prices typically trend upwards or downwards, and it’s not unusual to see such price barriers change over time. That’s why pattern definitions and trendlines are relevant when thinking about support and resistance.
If the market trends upside, resistance levels are established as the stock movement decreases and starts to shift back to the trendline. It is attributed to profit-taking or near-term volatility in a particular market. The ensuing pricing activity undergoes a “plateau” effect, or a small decrease in stock price, which produces a short-term high.
Most traders would pay particular attention to the price of a commodity as it sinks into the trendline’s wider support as, traditionally, this has been a region that has stopped the asset’s price from falling much lower. For example, as seen in the chart of Newmont Mining Corp (NEM) below, a trendline may provide many years of support for an asset. In this situation, consider how the trendline over an extended period of time helped the price of Newmont’s stock.
Conversely, as the market trends downwards, traders look out for a sequence of falling peaks and seek to use a trendline to link these peaks together. Once the price crosses the trendline, most traders may be looking for selling pressure on the asset and will consider taking a short position because this is an environment that has driven the market down in the past.
A defined degree of support/resistance, whether found through a trendline or by some other process, is known to be stronger the more times the price has traditionally been unable to cross it. Many technical traders would use their defined level of resistance and support to select strategic entry/exit points since these areas often represent the prices most important to the trajectory of an asset. Most sellers are confident in the underlying value of the assets at these levels and the volume then usually rises more than normal, making it difficult for traders to push the price up or down.
In comparison to the rational economic actors depicted by financial simulations, actual human traders and investors are irrational, make cognitive mistakes and rely on shortcuts or heuristics. If people were rational, levels of resistance and support wouldn’t really work!
Measuring the Significance of Zones
Recall how we used the words “floor” for support and “ceiling” for resistance? Continuing the analogy of the house, the security can be perceived as a rubber ball that hits the floor (support) in a room and then bounces off the ceiling (resistance). A ball that keeps moving between floor and ceiling is analogous to a trading instrument that experiences consolidation of price between resistance and support zones.
Now assume that the ball switches to a bowling ball in mid-flight. If added on the way up, this additional force will drive the ball through the level of resistance; it will push the ball through the level of support as it descends. This way, it takes additional energy, or excitement from the bulls or bears, to smash through the support or resistance. Often a former level of support will become a level of resistance as the market wants to climb back up and, conversely, a level of resistance will become a level of support if the price sinks briefly backward.
Price charts allow traders and investors to visually identify resistance and support zones and offer hints as to the importance of these price levels. More precisely, they consider:
Number of Touches
The more times a support or resistance area is tested by the price, the more the level becomes significant. When prices tend to jump off support or resistance, more buyers and sellers will note, and will base trading decisions on these levels.
Preceding Price Change
Support and resistance areas are expected to be more important where sharp advancements or declines precede them. For example, a quick, steep advance or uptrend will be met with more competitiveness and anticipation and may be stopped by a more substantial degree of resistance than a sluggish, steady advance. A gradual progress does not attract as much notice. It is a perfect example of how the technical indicators are guided by consumer psychology.
Volume at Some Price Level
The support or resistance level is likely to be stronger at a particular point when more purchasing and selling has happened at that price point. That is because certain market prices are known by traders and buyers and they are likely to use them again. When heavy trading happens at high volume and the price decreases, there is likely to be a lot of sales as the market recovers to that amount, because people are much more comfortable closing a deal at the breakeven point rather than loss.
Support and resistance areas become more significant if they have been frequently tested over a long period of time.
Support and resistance levels are one of the main principles used by technical analysts and form the basis of a wide range of tools for technical analysis. The fundamentals of resistance and support consist of the support level, which can be called the floor under trading prices, and resistance level, which can be considered the roof.
Prices crash and test the level of support that will either hold and the market will bounce back up, or the level of support will be broken, and the price will drop below the support and potentially go down to the next level of support.
Determining potential support prices will significantly increase the performance of a short-term trading strategy because it provides traders with a realistic idea of the level of the price that will prop up the price of certain security if a correction is made. Conversely, it would be helpful to predict a degree of resistance as this is a price point that might theoretically damage a long position, implying an environment where buyers are extremely eager to sell the security. As described above, when trying to define support/resistance, there are several different approaches, but regardless of the method, the result is the same – it stops the price of an underlying asset from going in a certain direction.