Identifying Support and Resistance Levels from Previous Price History – Part 2

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Identifying Support and Resistance Levels from Previous Price History – Part 2

October 24, 2020

I received some questions regarding this post and aim to address them all here.

One question was how many bounces do I look for when considering a level as “valid” or not. The simple answer is that I usually look for at least two bounces. Exceptions might be for recent extremes on the chart (top of the mountain/bottom of the valley) – for instance, high or day (HOD) and low of day (LOD). For S/R within a range, in particular, two prior bounces is definitely preferable (i.e., taking a trade on the third test of the level). However, if price action is supporting a reversal in the form of an extended consolidation zone (three or more bars), I’ll take it on the first bounce (i.e., second test). But I don’t have any mechanical rules, per se. A lot of identifying S/R levels is instinctive to me by just watching how the price behaves around a level.

For example, look at the figure below of a 15-minute USD/CAD chart:

Around the .99473 level, we see old resistance turn into new support and form an extended period of consolidation, which is ripe for put options. For about thirty minutes, price stayed under the level after the re-test, but came back up to test it again only to find further resistance. Later on, we saw more price consolidation around the .99167 level. There was a test of that level around 2AM EST (late Asian session) and it was re-tested again from 4PM-8PM EST. Although technically against the trend of the past half-day, price was holding well enough to consider call options.

When I identify these levels, I do it visually. I won’t mark them on a chart unless I want to set an alert. I usually just go by the 5-minute (5M) chart, though I will often look at the 15M, 30M, 1H, 4H, and 1D. I’m pretty familiar with the 4H and 1D charts since I base my forex trading primarily on those timeframes. Looking at the higher timeframes is very useful when there’s so much choppiness on the 5M that I can’t make sense of what the asset wants to do or have any idea of a valid level that might be the basis for a reversal or general consolidation. I have taken short-term binary trades based on S/R levels as far out as the daily timeframe, but most of the levels that I look at on the 5- and 15-minute charts are less than a day old.

I don’t set a strict limit on how many touches of a level are too many to the point where a breakout might be imminent. For that, you have to look at the price action and nature of the trend. If the candles are displaying more of a range, then that’s an indication that there’s more volume in the market and you might want to err on the side of caution. This is especially important for those who trade around my time (early-to-mid European session) when S/R created during the low volatility of the Asian session are bound to be broken.

The trend is also important. If you’re noticing that a certain price is holding but the retracements off the level are getting continually weaker (e.g., a descending triangle in cases of support; ascending triangle in cases of resistance) then you’re best off just watching the chart rather than taking a risk since your chances of winning are lower. In general, be wary of trading against the trend or momentum. “Short-term” trend (i.e., according to 5-minute or 15-minute chart) is usually more relevant to trading 5-30 minute expiries than “long-term” trend (i.e., according to the 30-minute chart or higher).

For example, in the case of this 15-minute EUR/TRY chart, although we see some price consolidation between 9PM and 10PM on the chart (between the areas marked as 21 and 22 on the time axis), taking call options at that point would be risky due to the recent downtrending market.

However, just after 11PM we see that the price level estimated at 2.34422 is a solid resistance area and retracements back up to that price level would be viable put option territory. Also note, that S/R levels are often subjective. They’re almost never a price “level,” per se, but rather a zone or general area where price consolidates. Whether you prefer to play it safe and take trades at the top or bottom of wicks or simply at the open or close of previous bars depends on one’s individual risk preferences. While in the case of a resistance zone, taking a trade at the top of a wick will yield a better trade, there’s always the chance that you might miss the trade altogether.

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Support and Resistance Basics

The concepts of support and resistance are undoubtedly two of the most highly discussed attributes of technical analysis. Part of analyzing chart patterns, these terms are used by traders to refer to price levels on charts that tend to act as barriers, preventing the price of an asset from getting pushed in a certain direction. At first, the explanation and idea behind identifying these levels seem easy, but as you’ll find out, support and resistance can come in various forms, and the concept is more difficult to master than it first appears.

Trading With Support And Resistance

Key Takeaways

  • Technical analysts use support and resistance levels to identify price points on a chart where the probabilities favor a pause or reversal of a prevailing trend.
  • Support occurs where a downtrend is expected to pause due to a concentration of demand.
  • Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply.
  • Market psychology plays a major role as traders and investors remember the past and react to changing conditions to anticipate future market movement.
  • Support and resistance areas can be identified on charts using trendlines and moving averages.

Support and Resistance Defined

Support is a price level where a downtrend can be expected to pause due to a concentration of demand or buying interest. As the price of assets or securities drops, demand for the shares increases, thus forming the support line.   Meanwhile, resistance zones arise due to selling interest when prices have increased.

Once an area or “zone” of support or resistance has been identified, those price levels can serve as potential entry or exit points because, as a price reaches a point of support or resistance, it will do one of two things—bounce back away from the support or resistance level, or violate the price level and continue in its direction—until it hits the next support or resistance level.

The timing of some trades is based on the belief that support and resistance zones will not be broken. Whether the price is halted by the support or resistance level, or it breaks through, traders can “bet” on the direction and can quickly determine if they are correct. If the price moves in the wrong direction, the position can be closed at a small loss. If the price moves in the right direction, however, the move may be substantial.

The Basics

Most experienced traders can share stories about how certain price levels tend to prevent traders from pushing the price of an underlying asset in a certain direction. For example, assume that Jim was holding a position in stock between March and November and that he was expecting the value of the shares to increase.

Let’s imagine that Jim notices that the price fails to get above $39 several times over several months, even though it has gotten very close to moving above that level. In this case, traders would call the price level near $39 a level of resistance. As you can see from the chart below, resistance levels are also regarded as a ceiling because these price levels represent areas where a rally runs out of gas.

Support levels are on the other side of the coin. Support refers to prices on a chart that tend to act as a floor by preventing the price of an asset from being pushed downward. As you can see from the chart below, the ability to identify a level of support can also coincide with a buying opportunity because this is generally the area where market participants see value and start to push prices higher again.

Trendlines

The examples above show a constant level prevents an asset’s price from moving higher or lower. This static barrier is one of the most popular forms of support/resistance, but the price of financial assets generally trends upward or downward, so it is not uncommon to see these price barriers change over time. This is why the concepts of trending and trendlines are important when learning about support and resistance.

When the market is trending to the upside, resistance levels are formed as the price action slows and starts to move back toward the trendline. This occurs as a result of profit-taking or near-term uncertainty for a particular issue or sector. The resulting price action undergoes a “plateau” effect, or a slight drop-off in stock price, creating a short-term top.

Many traders will pay close attention to the price of a security as it falls toward the broader support of the trendline because, historically, this has been an area that has prevented the price of the asset from moving substantially lower. For example, as you can see from the Newmont Mining Corp (NEM) chart below, a trendline can provide support for an asset for several years. In this case, notice how the trendline propped up the price of Newmont’s shares for an extended period of time.

On the other hand, when the market is trending to the downside, traders will watch for a series of declining peaks and will attempt to connect these peaks together with a trendline. When the price approaches the trendline, most traders will watch for the asset to encounter selling pressure and may consider entering a short position because this is an area that has pushed the price downward in the past.

The support/resistance of an identified level, whether discovered with a trendline or through any other method, is deemed to be stronger the more times that the price has historically been unable to move beyond it. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit points because these areas often represent the prices that are the most influential to an asset’s direction. Most traders are confident at these levels in the underlying value of the asset, so the volume generally increases more than usual, making it much more difficult for traders to continue driving the price higher or lower.

Unlike the rational economic actors portrayed by financial models, real human traders and investors are emotional, make cognitive errors, and fall back on heuristics or shortcuts. If people were rational, support and resistance levels wouldn’t work in practice!

Round Numbers

Another common characteristic of support/resistance is that an asset’s price may have a difficult time moving beyond a round number, such as $50 or $100 per share. Most inexperienced traders tend to buy or sell assets when the price is at a whole number because they are more likely to feel that a stock is fairly valued at such levels. Most target prices or stop orders set by either retail investors or large investment banks are placed at round price levels rather than at prices such as $50.06. Because so many orders are placed at the same level, these round numbers tend to act as strong price barriers. If all the clients of an investment bank put in sell orders at a suggested target of, for example, $55, it would take an extreme number of purchases to absorb these sales and, therefore, a level of resistance would be created.

Moving Averages

Most technical traders incorporate the power of various technical indicators, such as moving averages, to aid in predicting future short-term momentum, but these traders never fully realize the ability these tools have for identifying levels of support and resistance. As you can see from the chart below, a moving average is a constantly changing line that smooths out past price data while also allowing the trader to identify support and resistance. Notice how the price of the asset finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down.

Traders can use moving averages in a variety of ways, such as to anticipate moves to the upside when price lines cross above a key moving average, or to exit trades when the price drops below a moving average. Regardless of how the moving average is used, it often creates “automatic” support and resistance levels. Most traders will experiment with different time periods in their moving averages so that they can find the one that works best for this specific task.

Other Indicators

In technical analysis, many indicators have been developed to identify barriers to future price action. These indicators seem complicated at first, and it often takes practice and experience to use them effectively. Regardless of an indicator’s complexity, however, the interpretation of the identified barrier should be consistent to those achieved through simpler methods.

The “golden ratio” used in the Fibonacci sequence, and also observed repeatedly in nature and social structure.

For example, the Fibonacci retracement tool is a favorite among many short-term traders because it clearly identifies levels of potential support/resistance. The reasoning behind how this indicator calculates the various levels of support and resistance is beyond the scope of this article, but notice in Figure 5 how the identified levels (dotted lines) are barriers to the short-term direction of the price.

Measuring the Significance of Zones

Remember how we used the terms “floor” for support and “ceiling” for resistance? Continuing the house analogy, the security can be viewed as a rubber ball that bounces in a room will hit the floor (support) and then rebound off the ceiling (resistance). A ball that continues to bounce between the floor and the ceiling is similar to a trading instrument that is experiencing price consolidation between support and resistance zones.

Now imagine that the ball, in mid-flight, changes to a bowling ball. This extra force, if applied on the way up, will push the ball through the resistance level; on the way down, it will push the ball through the support level. Either way, extra force, or enthusiasm from either the bulls or bears, is needed to break through the support or resistance.

A previous support level will sometimes become a resistance level when the price attempts to move back up, and conversely, a resistance level will become a support level as the price temporarily falls back.

Price charts allow traders and investors to visually identify areas of support and resistance, and they give clues regarding the significance of these price levels. More specifically, they look at:

Number of Touches

The more times the price tests a support or resistance area, the more significant the level becomes. When prices keep bouncing off a support or resistance level, more buyers and sellers notice and will base trading decisions on these levels.

Preceding Price Move

Support and resistance zones are likely to be more significant when they are preceded by steep advances or declines. For example, a fast, steep advance or uptrend will be met with more competition and enthusiasm and may be halted by a more significant resistance level than a slow, steady advance. A slow advance may not attract as much attention. This is a good example of how market psychology drives technical indicators.

Volume at Certain Price Levels

The more buying and selling that has occurred at a particular price level, the stronger the support or resistance level is likely to be. This is because traders and investors remember these price levels and are apt to use them again. When strong activity occurs on high volume and the price drops, a lot of selling will likely occur when price returns to that level, since people are far more comfortable closing out a trade at the breakeven point rather than at a loss.

Support and resistance zones become more significant if the levels have been tested regularly over an extended period of time.

The Bottom Line

Support and resistance levels are one of the key concepts used by technical analysts and form the basis of a wide variety of technical analysis tools. The basics of support and resistance consist of a support level, which can be thought of as the floor under trading prices, and a resistance level, which can be thought of as the ceiling. Prices fall and test the support level, which will either “hold,” and the price will bounce back up, or the support level will be violated, and the price will drop through the support and likely continue lower to the next support level.

While spotting support and resistance levels on a chart is relatively straightforward, some investors dismiss them entirely because the levels are based on past price moves, offering no real information about what will happen in the future.

Determining future levels of support can drastically improve the returns of a short-term investing strategy because it gives traders an accurate picture of what price levels should prop up the price of a given security in the event of a correction. Conversely, foreseeing a level of resistance can be advantageous because this is a price level that could potentially harm a long position, signifying an area where investors have a high willingness to sell the security. As mentioned above, there are several different methods to choose when looking to identify support/resistance, but regardless of the method, the interpretation remains the same—it prevents the price of an underlying asset from moving in a certain direction.

3 Simple Ways to Identify Support and Resistance in Forex

Support and Resistance Talking Points:

  • Support and Resistance can help guide traders with entries and exits.
  • New traders often make it more difficult than it really is to identify these levels.
  • Learn how to use Psychological levels , Swing highs/lows, and Pivot Points.

“Support and resistance” is common jargon for areas on the chart where price has a difficult time breaking through. Support levels tend to stop price from falling below a specific point and resistance levels act like a price ceiling that price cannot break above. Knowing where these levels are make it much easier to decide when to open and close trades , but how can we locate these prices to begin with? Today we will cover 3 simple ways to identify support and resistance in Forex.

Psychological Levels

Often called “psych” levels, psychological levels occur when price ends with multiple 0’s. It’s human nature to gravitate towards round numbers when discussing any topic that involves numbers, Forex included.

For example, when traders talk about what they think the Euro will be worth in the future, they probably won’t give an answer of 1.4278 or 1.3044. They are much more likely to round off the price to something simpler, like 1.4300 or 1.3000. The same thing happens when Forex traders place their orders. We will often see clusters of orders around these whole numbers, which creates price levels that can affect how price behaves. That’s exactly what we want for our support and resistance levels.

The most common psych levels involve price having two zeros at the end (not including the 1/10th of a pip ), such as 1.64 00 or 102. 00 . More powerful than that would be psych levels ending in three zeros, such as 1.3 000 or 12 0.00 . Leaving the most powerful psych levels of all, four zeros at the end, 1. 0000 or 1 00.00 . The chart below has four levels drawn at psychological levels. We can clearly see their effect on price action.

Learn Forex: Psychological Levels

Swing Highs & Lows

Another great way to find support and resistance levels is to mark levels in the past where price had a difficult time breaking through. As price moves up and down, each level that price has bounced off of could be a level in the future that price bounces off of again. This is a manually intensive method and takes time to draw on all the currency pairs that we trade, but can pay off in the long run.

Learn Forex: Swing Highs & Lows Acting As Support & Resistance

As the EUR/USD chart shows above, a level was drawn when price reached a new high or low (red circle). Later when price approached these levels again, they bounced off the same levels (white circles). The effect will not always be this clean, but it does occur fairly often. This is a method used quite often in Range Trading . We can buy at support with our stop loss below and we can sell at resistance with our stop loss above.

Pivot Points

Arguably the easiest support and resistance levels to add to our charts, pivot points are a built-in indicator on many platforms that will automatically draw key levels without any effort on our part at all. Pivot points are created by the previous period’s High, Low and Close prices, with the most common period size being the Daily period. We can use these levels just like any other potential support and resistance levels on our charts.

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