- May 13, 2024
- Posted by: Mark S
- Category: Trading Article
In trading where prices fluctuate constantly, traders and investors seek to identify key levels that can provide clues into potential price movements. Among the most important concepts in technical analysis are support and resistance levels. These levels act as invisible barriers that can significantly influence the behavior of market participants and the direction of asset prices.
Support and resistance levels are price zones where the forces of supply and demand tend to converge, creating a natural equilibrium. These levels are not arbitrary; they come from the study of historical price action, revealing areas where prices have repeatedly found buyers (support) or sellers (resistance). By understanding and effectively utilizing support and resistance, traders can make better trading decisions, and improve their risk management strategies, as well as their overall trading performance.
How To Find Support and Resistance Levels
Finding support and resistance levels can be done in many ways and you could question each of them. How do you know your lines are any better than random? Here’s a fun test to do:
- Turn off your candlesticks or bars on your charts
- Start drawing random horizontal lines
- Turn your candlesticks back on
What are you seeing when you look at the chart?
- Do you see where the price has bounced from your random lines?
- Do you see where the price bounced a few times?
- Do you see where support and resistance switched roles?
If random lines seemingly reject price, how will you make sure your lines are valid?
One way to determine your support and resistance levels is to use a basic market trend structure.
- A market in an uptrend will produce higher highs and higher lows.
- A market in a downtrend will produce lower highs and lower lows
- A market in a range will produce both
“Usually, a support level is identified beforehand by a previous reaction low,” and “a resistance level is identified by a previous peak” (Murphy 1986)
Understanding how to accurately find support and resistance levels is important for them to have any use. These levels serve as critical markers for traders, helping with their entry and exit points, and offering insights into potential trend reversals or continuations.
Let’s dive into the nuances of some of the most effective techniques to pinpoint these crucial levels.
Traditional Horizontal Levels: Connecting Highs and Lows
Basics of Horizontal Levels
Traditional horizontal levels are foundational in technical analysis. By connecting the most obvious highs (resistance) and lows (support) on a chart, traders can identify key areas where the price has historically found support or faced resistance.
For instance, if a stock price has bounced back from a particular price level multiple times, it indicates a strong support level. Conversely, if it has been repelled from a certain level repeatedly, that’s resistance.
Tips for Drawing Horizontal Levels
Always use a clean chart and start with higher time frames, like the daily or weekly charts, to identify major support and resistance levels. The more times a price touches a support or resistance without breaking it, the stronger that level is.
Psychological Levels: The Role of Round Numbers
The Power of Round Numbers
Round numbers, such as $10, $50, or $100, hold a special place in the minds of traders and investors. These levels often serve as significant psychological barriers in the market, influencing the behavior of market participants and, consequently, the price action of an asset. But why do round numbers matter so much? The answer lies in their simplicity and ease of recall.
Traders and investors often use these levels as mental benchmarks, making them more likely to place orders around these prices. This collective focus on round numbers can create self-fulfilling prophecies, as market participants anticipate reactions at these levels and act accordingly.
Incorporating Round Numbers in Your Trading Strategy
Understanding the psychological significance of round numbers can help you make more informed trading decisions. However, it’s essential to note that round numbers are not foolproof and should be used in conjunction with other technical analysis tools and market context.
One strategy to consider is setting your orders slightly above or below round numbers. By doing so, you can potentially avoid the rush of orders that often occurs right at the round number level. This can help you secure a better entry or exit point, as you’ll be ahead of the crowd. For instance, if you anticipate a breakout above a resistance level at $100, you might consider placing your buy order at $100.50 or $101.
This way, you’ll enter the trade after the initial breakout momentum, potentially reducing your risk and increasing your chances of a successful trade.
Swing Highs and Swing Lows: Understanding Candlestick Wicks
In candlestick charts, the thin lines extending above and below the candle’s body are called shadows or wicks. These shadows represent the extreme price levels reached during a specific trading period. Swing points, which include swing highs and swing lows, are crucial candlestick formations that traders use to identify potential trend reversals and gauge market sentiment.
Fibonacci Retracements: Drawing Levels Using Fibonacci Ratios
The Golden Ratio
Derived from the Fibonacci sequence, these retracement levels (23.6%, 38.2%, and 61.8%) represent potential reversal areas in the market. By drawing horizontal lines at these percentages from a major peak to a trough, traders can anticipate potential bounce-back levels.
For instance, if a stock drops from $197.96 to $90, a 38.2% Fibonacci retracement would be at $169.57, indicating a potential support level.
Identifying Strong vs. Weak Levels
Levels on a chart do not always carry the same weight. Some levels seem to provide a “stronger hold” and this is usually due to the recent price action surrounding the level. I want you to see a breakdown of how I locate levels whether trading breakout or pullback strategies.
- Some type of trending pattern and this example is an uptrend
- Once a swing high is put in (HH), the price rejects from the price point (resistance) and then exceeds resistance, we will mark that area as former resistance and POTENTIAL support.
- At the point marked “A”, you can see we have a higher low and then a lower high. This negates the uptrend pattern and you can see price has put in a triangle pattern.
- At the point marked “B” the price holds inside of highs and lows and it’s labeled a trading range
- Price breaks lows of range and rejects off previous resistance which has now produced a support level
You will want to note that price will not always return to a former “reaction low” as mentioned by Murphy in the quote above.
There will be times when price will return to the former area of resistance and that zone will act as support as buyers enter the market.
This is a simple and objective price action method to identify your support and resistance zones using a pure market structure. You can also use prior day highs and lows for your financial instrument but with markets heading to 24-hour trading (Forex is already there), you may want to define the time you use for open and close such as 5 P.M. New York.
Don’t get too caught up in exact price points with your lines. Remember these are zones. Price is rarely perfect.
Psychological Significance Behind Support and Resistance
Trading based on support or resistance levels alone is like trading with blinders on. It’s easy to identify specific prices that have historically demonstrated their value as support or resistance and the temptation which follows is to take a trade at the price when the level is revisited.
Every trader, regardless of their experience level, has encountered the moment when a stock price approaches a previously established high or low, and the question arises: “What’s next?” The significance of support and resistance levels goes beyond mere numbers; it’s a reflection of the collective psychology of market participants.
The market, at its core, is a manifestation of collective human behavior. When a price nears a previous high, traders are reminded of the past. They vividly recall the resistance encountered, the intense selling pressure, and the potential losses suffered. This shared memory, often fueled by the fear of repeating past mistakes, has the power to halt a bullish trend in its tracks, effectively confirming that price point as a resistance level.
Conversely, when prices decline to a previously established low, a sense of “have we gone far enough?” begins to emerge. Traders recall the bounces, the attractive buying opportunities, and the profits that followed. This gives them a sense of optimism, a belief that the instrument has found a bottom, leading to increased buying activity. This collective optimism forms a floor, or support level, where the price tends to bounce back.
The combination of collective fear and greed, hope and despair, is a constant presence in the markets, and it shows up daily in the charts we analyze. By understanding the psychological impacts of support and resistance levels, you can gain valuable insights into market movement and make better-informed trading decisions.
Problems With Drawing Trend Lines For Support and Resistance
I know some chartists will challenge me on the use of trend lines but you will find that many long-time chart technicians have forsaken the trend line not only for support and resistance but also the chart patterns that use them. Why?
Let’s explore an example and look at trendlines and the main issue with using them for price patterns.
After two peaks, I can draw a trend line to connect the points. Traders that play breakouts of trend lines will monitor price as it breaks the line. In this example, each break of the trend line rallied but stopped dead in the tracks right near the horizontal resistance line. If you were a long trader this would have caused you grief as the market continued to pull back against you.
It wasn’t until the price consolidated under the horizontal resistance line (a bullish sign) that we eventually got a strong break of resistance for a long trade. That’s not to say you can’t use trend lines in this manner. Just be on the watch for horizontal support and resistance levels that may cause a speed bump or detour.
Support And Resistance Zones Must Eventually Break
However, if all levels were going to hold all of the time the markets would never move. So the question is if you are going to enter at levels of support or resistance, which do you choose and when are they valid? One determining factor you may use to determine a “strong level” is the amount of time the price is rejected at each data point.
That is not a good trading method.
Hits on a support or resistance level weaken the level over time Each time the price revisits a level, stop loss orders accumulate underneath the zone as you can see by the increasing line thickness.
These make prime areas for an influx of order flow as these orders are triggered. Depending on the number of stop-loss orders beneath the support line and the number of breakout traders standing by, the price can move fast and hard away from the level.
You can note by the green circles that once you start to see the price not rallying far from the level or the price begins to base at the zone, extra caution must be taken if you are considering a trading opportunity.
To trade at a level it’s important to see context, confluence (ideally other reference points aligning), and the right sort of trading activity on approach, all working together.
Moving Averages To Define Dynamic Levels
We’ve all heard about moving averages such as the 50 period average, the 100, 200, and even 20 periods. Many traders believe that these lines act as “dynamic” support and resistance levels. Dynamic as in they change with price.
The truth is the calculation of the moving average needs, as an example, 50 data points which are generally the closing prices. As the price begins to lose momentum, the range between closing prices gets smaller. The moving average will then draw closer to price giving the illusion that it is supporting price. It isn’t.
It is just the moving average calculation taking place as the closing prices between each day are not as wide as they were previously.
How To Trade Support and Resistance Levels
Since we understand that all support and resistance levels can break, how do we take a trade from the level? Remember, support and resistance zones are market reference points that allow you to have some structure to your trading decisions at locations where there is potential for price movement.
You don’t have to trade support and resistance zones to get the benefit of them.
Seeing how price reacts to these points can be just as valuable depending on your trading strategy. Once you’ve determined support and resistance zones that you will keep an eye on, the next stage is to watch for signs that the level will either hold or fail.
- A strong drop in price and a long tail candlestick (pin bar, kangaroo tail) reject the previous resistance now acting as a support level. We’d call this minor support since the price has not been visited before this event.
- This is the first peak but highlights a bearish candle that takes out the real body of the bull candlestick. This is a move you can trade
- Another rejection of support is now called major support since it has rejected prices more than once.
- Engulfed candlestick at major resistance
- Price consolidates at support with an obvious resistance line.
- Price then consolidates at the top of the range which indicates bullish intent. You can position it inside this smaller range.
- Lack of bullish momentum at resistance as shown by smaller candlesticks.
- Range with obvious support and resistance levels. A strong break of support and price pulled back to test. After the price breaks all previous support, a pullback trade sets up another shot to the downside.
This one-chart example has shown many candlestick formations that you can look for in these zones.
False Breakouts Of Zones Are Common
Many breakout traders get nailed when price tests a level, appear to want to break, and then simply snap back up. These are called false breakout or, a more accurate label, failure tests.
In this chart, the price has run into resistance and pulled back. You know that traders have been going short or exiting longs because the price had not broken through. Remember what we talked about earlier? Protective stops are accumulating just beyond resistance and the traders on the sidelines are waiting for price to break resistance so they can go long.
At the right of the chart, the price runs from the low end of consolidation, and after a small battle as indicated by long lower shadows, the price pops the resistance area at the black arrow.
Price had a decent run but eventually slammed back almost closing below the open. Is this the sign of a successful breakout? No. By the looks of the massive bear candlestick that wiped out 3 days of gains, those that went long are getting hammered.
After a brief consolidation, hopeful bulls see the end is near and the second huge momentum candlestick indicates the probability of other shorts entering the market and bulls finally exiting their position.
False breakouts of support and resistance, even if you don’t trade them, tell a story that the zone is still of interest and acting as a barrier to price. That may aid you in taking a trade short in virtually any trading strategy.
Shorting At A Support Zone Example
The general rule is not to short into support or buy into resistance.
That’s a rule that may be ignored and price action will dictate behavior (this happens to be my favorite setup).
- Strong momentum moves to the downside and price rallies giving us a support line and resistance line.
- Price drops back to support at the first green circle but buyers hold the move
- The second green circle shows sellers stepping in strong but the slight drifting upwards after shows bulls holding on
- Price drops and begins to consolidate
- The last green circle shows the price dipping below the support level of the range and popping back inside.
- Price is unable to gain traction to the upside
This is a prime location to enter the trade!
Price action has shown you that in this critical area, the bears are the ones holding the cards.
Your stop would not be placed just above the zone (remember stop runs?) but you may use an ATR stop as an example.
You are positioned before the break which means:
- Before stops are triggered
- Before the breakout traders step in
It is not uncommon to ride the wave of momentum and be up a considerable amount long before others get wind of the trading opportunity.
Identify Support On Higher Time Frames
It’s important to analyze higher time frames to identify support and resistance levels that may be near the current price. By examining time frames that are 3-5 times higher than your primary trading time frame, you can pinpoint potential obstacles that could stall price movement.
For instance, if you spot a compelling buy signal on a daily chart, consult the weekly or monthly chart to determine if there are any nearby resistance levels. Higher time frames typically exhibit fewer levels compared to lower time frames, making these levels more apparent to a broader range of market participants.
Initiating a long position near a resistance zone on a higher time frame can lead to a challenging trade, as the price may face rejection at these higher levels. In such scenarios, it might be more appropriate to consider a short trade, taking advantage of the potential selling pressure at the resistance level.
By incorporating a multi-timeframe analysis into your trading strategy, you can gain a more comprehensive understanding of the market structure and make better-informed trading decisions. This approach allows you to anticipate potential roadblocks and adjust your trades accordingly, ultimately improving your risk management and overall trading performance.
Conclusion
The assumptions that either levels ‘work’ all the time or they are non-existent, are flawed. Once you understand what they are, you’ll see just how useful they can be whether you day trade or swing trade regardless of the time frame chart you are using.
Support and resistance zones will either hold or break. That’s it. Find your method of determining which one has a higher probability of occurring and take action.
Keep in mind that if a level breaks, you don’t expect the price to come roaring back inside of the level. You expect pullbacks into the breakout zone to be weak. This is where understanding what a failure looks like at the zone.
Trading support and resistance is a viable part of a trading strategy that includes risk management and trading psychology. Practice locating and drawing your levels and monitor the behavior of price when the line breaks and when it holds.
Hands-on is the best teacher so crack open your charts and start perfecting your use of support and resistance trading.
FAQ
1. What is the psychological significance behind support and resistance levels?
Support and resistance levels are not just about numbers; they reflect the collective psychology of market participants. When a price approaches a previous high (resistance), traders remember the past resistance, selling pressure, and potential losses, which can halt a bullish trend. Conversely, when prices drop to a previous low (support), traders recall the rebounds, buying opportunities, and gains, creating a sense of optimism and a potential floor for the price.
2. What are some common problems with drawing trendlines for support and resistance?
One main issue with using trendlines for support and resistance is that they may not always align with horizontal price levels. A price may break a trendline but then face resistance or support at a horizontal level. Trendlines can be useful, but traders should also be aware of key horizontal levels that may act as barriers to price movement.
3. Can support and resistance levels eventually break?
Yes, support and resistance levels can and do break. If they never broke, markets would never move. Each time the price revisits a level, stop-loss orders accumulate underneath the zone, creating the potential for a strong breakout. Traders should watch for signs of weakening support or resistance, such as price consolidating near the level or failing to rally significantly after touching it.
4. How can moving averages be used to define dynamic support and resistance levels?
Moving averages, such as the 50, 100, or 200-period averages, can act as dynamic support and resistance levels that change with price. However, it’s important to note that the moving average calculation itself does not directly support or resist price. As price momentum slows, the range between closing prices narrows, causing the moving average to draw closer to the price, giving the illusion of support or resistance.
5. What should traders do when a support or resistance level breaks?
When a support or resistance level breaks, traders should not expect the price to immediately reverse back inside the level. Instead, they should watch for weak pullbacks into the breakout zone, which could indicate a potential trend continuation. Understanding what a failure looks like at these zones is crucial. Traders can use breakouts as entry signals, but should always consider risk management and other technical indicators when making trading decisions.
