Trading Based on Support and Resistance Levels
The most common feature of any market, is that price is never constant. It either goes up or comes down, depending on the forces of demand and supply. In the forex market, price may go up, come down, or range (neither go up nor come down due to an indecisive market). Sometimes price reaches a high but cannot seem to surpass this level, other times it hits a low level but can’t seem to break through this point. This is where support and resistance levels are introduced.
After understanding how trends work, another basic skill required to trade the forex market is the ability to identify support and resistance levels. These levels indicate the struggle between buyers and sellers the or the struggle between demand and supply.
Support and resistance are key levels where price can’t seem to break through. To understand support and resistance levels, it’s important to understand how price moves in the forex market. In financial markets, like the forex and stock market, price signals are driven either by excessive supply which drives price down or excessive demand, which drives prices up. Excessive demand signals a bullish market while excessive supply signals a bearish market. An increase in demand will drive price further upward while an increase in supply causes a decline in price (Stock Charts).
A support level is the price level in which the downtrend in price can’t seem to break through. Once price reaches this point, it bounces back upward. Support and resistance lines can be said to be established by taking note of the previous lows or highs of price. Let’s say you initiated a trade for the EUR/USD at 1.5682, a downtrend occurs and price drops to 1.4987. If price had dropped to this level before you initiated your trade at 1.5682, 1.4987 would be the support level, because when price reaches that point, it bounces and starts an upward trend (Investopedia). Support lines are formed when the price of a currency pair drops, and as a result, demand increases. They are usually found beneath the current price of a currency pair.
Resistance level on the other hand, is a simple reversal of the support level. It is the level at which the uptrend can’t break through. Once price reaches this level, it bounces downward. Using the previous example where you initiated the EUR/USD trade at 1.5682, and price rises to 1.6230. If price had previously hit this level before bouncing downward, then 1.6230 can be deemed to be the resistance level. At this level, there is a strong supply, and this supply stops price from increasing. The resistance line is formed when the price of a currency pair increases, and as a result supply increases and price begins to drop (Fidelity).
The psychology behind trading support and resistance levels, is that as price approaches resistance level it hits a high, and rather than continue to buy at this high price, traders become more inclined to sell and less inclined to buy. The reverse occurs when price approaches the support level. Support levels tend to stop price from falling lower, while resistance levels stop price from increasing.
However, these price levels don’t always hold. When price breaks through a support or resistance level, market psychology shifts and new support and resistance levels are established. When price breaks a resistance line, that line becomes the support. Similarly, when a support level breaks, it becomes a resistance level, but false breakouts are extremely common when trading using support and resistance. During false breakouts, price breaks the resistance, forms a new support, but after a while, price returns back to the old resistance level then drops further (Investopedia).
There are several ways to identify support and resistance levels. These methods can be as simple as connecting previous tops and bottoms to checking candlestick patterns, or can be a little more complex such as using technical indicators such as trend lines, moving averages, Bollinger bands, and even using Fibonacci retracement levels (XTB).
When trading using support and resistance, certain factors are important, in order to cut back on potential losses.
Since false reversals are common when using support and resistance levels, trading this way can be extremely risky. In order to avoid blowing your account when trading using these levels, it’s important to place a stop loss order. Support and resistance levels can also help define your risk amount, while determining the best place to place your stop order.
Determine the market environment
The market is always either in an uptrend, a downtrend or is ranging. The ability to identify the environment you’re trading in, helps in the determination of support and resistance levels, and also in determining whether price can break these levels. This can help you allocate your risk, and determine when to enter a trade (DailyFX).
Combine with other technical Indicators
Trading only using support and resistance lines is extremely risky, and in order to minimize trading risks, it’s better to combine this analysis method with technical indicators in order to confirm price action.
Types of support and resistance and how to use them
- Traditional swing highs or lows
These kinds of levels are found by looking at a longer time frame, such as the weekly or even monthly chart. This way we can identify how price has been moving during the specified period of time. It helps identify the major support and resistance levels, as well as the trends, and trading range of the selected currency. After this, you can zoom in on the daily chart and identify the highs and lows for the day. Doing this gives you a broader view of how high or low price can go in case of reversals.
- Stepping swing levels in trends
This involves noting old resistance and support levels and retracing back to them when price breaks new levels. Thus, you need to mark new levels as they form, when old support becomes a new resistance or old resistance becomes new support. These retracement levels provide good points to enter a trade as well as great points to place take profit / stop loss orders (Learn to Trade the Market).
- Swing point levels as containment and risk management
Although swing points are not part of a trend, they can be used as a risk point to define your trade. Swing points occur when price breaks support or resistance levels slightly. You can choose to buy or sell at a swing point if price stays contained at that level. In order to prevent heavy losses if your trade is rendered invalid, place a stop order just beyond that level.
- Dynamic support and resistance levels
This involves the use of moving averages, and is used mostly on the daily chart, though it can also be used on the weekly chart time frame. Moving averages are used here to determine the direction in which price is going, allowing you to jump in on the trend. When using moving averages, you can wait for the market to test the moving average by breaking above or below it, before initiating a trade near the moving average (Learn to Trade the Market).
Other types of support and resistance include; trading range support and resistance, 50% retracement levels, Fibonacci retracement levels, and event area support and resistance