It is time to touch upon one of the cornerstones of technical analysis; Support and Resistance. When traders talk about support and resistance, they are talking about price levels at which they expect the market will have a difficult time rising above or going below. The term “Support” refers to any level which has proven to support the price in the past. A support level act as a floor for price action. On the other hand, the term “Resistance” is given to any price level which has proven to resist price action in the past. In these chases resistance levels act as a ceiling for price action. These levels can be drawn as lines on your price charts, which allows you to quickly determine where potential price action might happen. Spotting key support and resistance levels is the most important tool in a chartists toolbox.
Drawing these support and resistance levels is usually done using horizontal lines on the charts. It is important to realize that those lines aren’t really lines – they are zones. Don’t expect that price action will react perfectly on them. Sometimes price action will reverse slightly before a support or resistance line, sometimes it will move a little beyond. A reversal in price action happens when price action reaches a point where many buying or selling orders are located. With drawing support and resistance lines we try to make estimated guesses of where all those orders are located. When the price action eventually moves into these predicted zones slowly these orders start to get filled and if there are enough orders to counter the current price action the market reverses. These orders aren’t placed and executed at exactly the same time, therefore the market will rarely respond perfectly on support and resistance levels.
Three possible ways to find support and resistance levels are horizontal, dynamic and trend lines/channels. These types are explained below.
Horizontal Support and Resistance
Most common form of support and resistance levels are horizontal. They are identified by finding levels that price action has bounced off from in the past. If price action has bounced off a certain level for numerous times before, traders will likely to buy around such levels in the expectation that it will bounce again.
It is not uncommon that horizontal support and resistance levels are zones close to round numbers. Like in daily life were we are attracted to round numbers, so also the forex market. There is nothing significant about them besides the fact that the masses of the traders respond to them. For this reason if price action moves towards a big round number it will likely respond to it as at least a temporary support or resistance.
That leaves us with the question what happens if a support or resistance level is broken. A well-known saying states that “what was once support becomes resistance: and what was once resistance becomes support”. Meaning that if price action breaks through a support, the price when it retraces will move back into former support zones that will now act as a resistance. This so called “break and test” is considered a high probability entry point.
Trend Channel & Trend line
In some occasions it is possible to tilt horizontal trend lines to find support and resistance. These angled lines are often found when a market is trending, and are therefore called trend lines. When the market is in an up-trend, the line is drawn under the swing lows. This creates a line that acts as a support level for the trend. The retracements towards the support line often signals a high probability entry point for the next move up. Vice versa in a down-trend, the line drawn over the swing high acts as resistance for the trend. Same here, the pullback towards the resistance line often signals a high probability entry point for the next move down. A trend channel is formed when these a support and resistance trend line move parallel to each other.
The stronger these trend lines, the more likely they will hold. Once a strong trend line is broken, it often signals a trend change may be taking place. As with horizontal support and resistance levels, once a support is broken it becomes resistance and vice versa. Three important features to determine the strength of a trend line are:
- The amount of times it bounces off from it;
- Its duration (time); the longer a trend line hasn’t been broken the stronger it gets;
- The slope; a minor slope signals a weak trend, while on the opposite, a very steep slope is usually unreliable and easily broken. Ideal trend lines tend to have a 45 degree angle.
Dynamic Support & Resistance
Besides horizontal support and resistance or trend lines, which are straight lines, there are also dynamic levels. For finding dynamic levels it is common practice to use technical moving average indicators. A moving average indicator, or short MA, is a trend indicator that takes the average of the last n-trading observations. Popular MA are 10, 21, 50 and 200-period. The direction of the price action will influence the values of the MA indicator. Dependent on the length of the period it will respond quickly to a strong up move or not. Like previous highs and lows can act as support or resistance, so can moving averages. When a key MA is violated it often signals a trend reversal. For detailed knowledge on the different types of MA and how they work check: moving averages.
How to draw support and resistance lines?
Since support and resistance lines are drawn manually onto your charts they are subject to personal opinion and perception. Trader A might have a different opinion on whether there is a support level or not. If the rest of the market may not agree with your lines, it will be likely that price action will not react to your line. To prefect that from happening there are two basic rules to drawing lines which will help to improve your accuracy:
- Draw your lines through the open and close prices. The open and close price are more significant than the high and lows of a candle.
- A line should touch at least three times. The more touches, the stronger the support/resistance.
If you have drawn a trend line it’s critical to continuously monitor and adjust the angles to get the proper one. Therefore, changing the channel angels to conform recent price action will help traders in finding top resistance and bottom support points. The initial thrust is likely not the angle the trend will take on the intermediate or longer term. Instead by connection the first pullback low with subsequent lows, you will likely be better able to get more accurate intermediate and long term trend lines/channels. The same holds true for top resistance lines, connecting subsequent swing highs or intermediate highs.
Drawing both trend lines on the highs and lows, you find these lines often move parallel from each other. A regular bull- or bear-channel, often moves in parallel channel line formations at approximately 45-degree angels. Which is already an important fact to know in order to determine if a trend is moving in- or out of pace. A trend moving out of pace can signal a good moment to get out of a trade.
Leaving previous Support & Resistance lines on your graph
Often prior strong support and resistance levels are valid even years later, as price will often test or retest these levels when currencies change direction and begin a new trend. For this reason it is advisable that traders leave key support and resistance lines on their charts for a while. A major advantage of drawing lines is that it helps to quickly spot levels which should be monitored closely when price approaches them.