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Two Rules For Support And Resistance
Support and resistance are one of the most basic forms of technical analysis. Like many other tools of the trade, being basic does not make it simple. Identifying and using support and resistance, S/R, successfully as part of your daily trading routine takes time and practice. I am here today to help you gain an understanding into what S/R is, what it means and how you can profit from it. Like a moving average, S/R is a simple line drawn on a chart. Also like moving averages, S/R can be used in a variety of ways to generate signals and identify areas where the market is likely to continue or reverse its direction. The thing is, these lines in and of themselves are not signals. Price action does not indicate a buy or sell simply because it reaches one of these lines and that is why so many newbies have a hard time employing this tool.
The first rule of S/R is that it is not a signal. These lines are target areas where signals may occur in the same was Fibonacci Retracements. If you do not know about this tool read my Three Rules For Trading With Fibonacci Retracements. When price action reach one of these lines then you begin to look for a confirmation in other indicators and the prices themselves. Stepping back a bit lets look at what S/R and S/R lines are. These lines demarcate areas of accumulation and distribution on your chart. This analysis is so vital to trading that there are many tools dedicated to it such as the Accumulation/Distribution Line. Accumulation is the term used for an area where the market is net buyers. As the market buys more of an asset it is said to “support” prices, or keep them at or near a certain level. Distribution is the term denoting an area where the market is net sellers. As the market sells more of an asset it it is said to provide “resistance” to higher prices. Together these two lines can create areas of reversal, provide fuel for break outs and even trap prices within a range. There are a few key areas for drawing S/R lines and they include peaks or troughs, congestion bands, recognizable price patterns, areas of previous reversal and others. Drawing your lines takes practice but once you get the hang of it will come with ease.
Let’s talk about time frame for a minute and then we’ll look at a chart. Support and resistance is effective in all time frames. The longer the time frame used to determine the S/R line the stronger the potential buying or selling will be. For example. A line drawn from a peak on a chart of weekly prices is stronger than a line drawn from a peak on a chart of daily or hourly prices. This is important to note because an S/R level from a higher time frame from the one you are trading in will impact your trading whether you know it is there or not. Also, keep in mind that once an area of support or resistance is identified it usually never stops being important. It will affect price action every time it approaches, no matter how much time has passed. I know this from experience and you can see it on the charts. Look below at the chart of the CBOE Gold Index. This is a ten year chart of weekly prices. You can see that levels of support and resistance from 2007, 2008 and 2009 affected prices in 2020, 2020 and 2020.
Support And Resistance Zones
Sometimes support and resistance can be a little harder to define. Sometimes it can be zone of support or resistance rather than a signal price. These zones can form in a number of ways but are typically just an area where two or more potential S/R levels exist. As an example, a weekly candlestick with a long upper or lower shadow would have two potential areas of S/R, at the close and at the high/low of the day. Take a look at the chart of daily Gold Index prices below. On this chart the index is trending sideways making many peaks and troughs within the same range. Several potential zones have formed, I have marked two, one is an upper resistance zone, the other a lower support zone. Notice how sometimes a signal will come at the line, while other times it will occur inside the zone. This is why awaiting a confirmation is so vital when trading with this method.
So, the second rule for trading with S/R is that you must wait for confirmation. The lines are not a signal and there is no guarantee that an S/R line will hold when prices reach it. There are many other factors involved when trading and other indicators are a recommended. I like to use oscillators like MACD and Stochastic as well as other tools like Fibonacci Retracements, Bollinger Bands ™ . These indicators can give you insight into what may happen when prices reach a line you have drawn.
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
- 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.
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.
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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.
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!
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.
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.
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.
Support and Resistance Zones – Road to Successful Trading
This Support and Resistance Zones Strategy will enable you to take trades exactly at the area price will reverse. Trading support and resistance lines are critical for every trader to implement into their system. In this article, you will learn how to calculate support and resistance, identify support and resistance trading zones, stock support and resistance approach to trading, along with forex trading support and resistance.
I am going to guide you every step of the way. Follow along as we cover support and resistance in forex, how to trade support and resistance in stocks, and how to trade support and resistance in options. This is a simple, easy to learn and easy to understand trading strategy. After you read this strategy, you will be able to identify these sweet spots where marvelous price action happens. So, keep reading and you won’t regret it. Also, read trading discipline which is an important skill for successful trading.
What indicator are we using for this strategy?
Indicators Used in the Support and Resistance Zone Strategy
Our indicators for this strategy will be price action and its relationship to Support and Resistance. to be honest, this is, in our opinion, the best way to trade support and resistance. So what exactly are these key areas? How to trade support and resistance levels? Before we explain the strategy we are going to define support and resistance. Here is another strategy called The PPG Forex Trading Strategy.
What is Support?
We have a specific article on this very topic so go ahead and read that here if you do not know what support or resistance is. Support is the level where price finds it difficult to fall below until eventually it fails to do so and bounces back up. It’s simply many traders making trading decisions at that level.
What is Resistance?
Resistance is the level where price finds it hard to break through to rise above it until it fails to and is pushed back down.
You should always suspect a reversal at Support and Resistance as there is a high probability that price action will reverse at those key levels. That’s because it already did that before in the past and it will continue to do so in the future as traders will always take caution on these levels. Some who had open trades will exit at those price levels and others will initiate new trades at these levels. That’s why it is crucial to learn to draw these Zones using technical analysis.
Steps for Trading Support and Resistance Zones Strategy
Now that we know the role of S&R Lines, which from now on we will call Zones. That’s because support and resistance are not a given line. If so, it would super easy for traders to know and every trader on the planet would have an entry order at that price.
They are more like zones that can be breached and pushed into. The trend may pull the price action back out of it, or maybe price action will succeed in breaking it for good. This is why you want to think of these points as zones.
Our main purpose in this Trading Strategy is to identify those Zones and use them for our favor and make great trade entries and exit points.
The First Step of the Support and Resistance Zone Strategy.
The first step of this strategy is drawing those Zones on our charts. This allows us to easily spot where the price would probably reverse. After you do this, it will resemble a support and resistance indicator only you now have zones to take advantage of. Drawing Zones on the chart is better done on a higher time frame so that we can examine the main reversal levels and the more critical points on the chart as a higher time frame shows us the bigger picture. It’s almost like what we talked about in our article about the importance of multiple time frame analysis.
We begin by drawing horizontal lines on recent Peaks and Bottoms like you see below in our chart example: Examine this chart as it is critical for you to understand these zones.
When you are doing support and resistance trading, a line with multiple touches is far better off as it is clear that it stood against the price and passed the test many times and it will continue to do so. WHY?
Because History always repeats itself and this continues to happen time and time again on every chart that you will ever look at. (Stocks, Options, Forex)
Note** Make sure to leave spaces between zones as drawing many lines will confuse you and worsen your trading decision. This strategy could easily be compared to our Red zone strategy that shows you how to draw zones on your chart.
When you take a look back after drawing Zones will find that those lines withheld the price numerous times before and will continue to do that numerous times more.
The Second Step to Identifying Support and Resistance Zones:
The second step is waiting for the price action to touch the Zone. What you can do is set your charts on 2 to 4 currencies and wait for your chance, as it may take some time for the price to reach the support resistance levels. The reason we say 2 to 4 currencies is because this is a good number of pairs to be looking at and will not overwhelm you. This allows you to have a good judge on your trade opportunity.
Basically, the higher time frame takes less time and attention than the smaller time frame. Alternatively, the smaller time frame has more signals as the zones may get hit more frequently. You have to be more focused if you’re trading small time frames.
In this chart we see the price action approaching support and actually almost touched the support so we wait to see the form and shape of the next candle.
If the price reverses that will be good, as it is what we are expecting. We will need a strong reversal candle though to assure that price will reverse and that it will not collapse back again.
On the other hand, if it breaks that level, it may be real breaking or a fake breaking. We also should see a strong piercing candle that effortlessly breaks that level to assure it will continue in the same way.
The Third Step for the Strategy Is:
The third step of this trading strategy is to wait for the candle which hits the zone to close. This will indicate the signal candle we are waiting for. Take a look at the candlestick pattern and ask yourself:
- Is it a bullish or bearish candle?
- Is it strong or weak?
- Big or small?
- Does it have long wicks or small wicks or no wicks at all?
When you can identify the kind of candle then you will be able to decide whether to sell short or buy long.
Knowing the type of candle is crucial to identify whether the entry is valid or not.
In the chart example above we see how Support rejected the price and pushed back up. We also see the candle that formed afterward to signal the end of the down movement and the beginning of and upward movement.
So how did we know it is strong, what it’s secret?
Before we go any further, here are some important factors in determining a strong candle. Because spotting that specific candle on zones makes the difference between winning trades and losing trades.
The Qualities of a strong candle are:
- Long body
- Formed after the previous touched the level but could not break it.
- Entirely taken the two previous candles.
This example shows us how a strong candle should look. As you can see, the strong candle overpowers the one before.
Here, you can see that those weak candles were not able to breach the Resistance line and had long wicks and could not break that level. So, we wait to see what will happen with the next candle. Will the price action break that level? Or will the resistance win and the price reverse?
On the first case ( the candle on the left that we marked for you): clearly, the price fell on the next candle which made it a valid reversal.
While in the second case ( the candle on the right that we marked): we had a very small candle which did not mean anything except that the resistance stalled the price for a while.
The Fourth Step to This Support and Resistance Strategy After You Analyze Your Zones:
The fourth step is to identify where you will enter the trade. You want this to happen at the pivot point or turning point. Here are the entry criteria.
Entry/Exit Criteria for This Support and Resistance Trading Strategy:
Your entry should be slightly above or below the signal candle which is the strong candle. This way you are adding more confirmation to your trade to make sure that the price will move towards the direction you expected it to move to.
Our stop loss should be placed on the other side of the zone and not too close to the level to give it some space. As we said, it is a Zone. Putting the Stop loss there makes sense because this is the end of the trade. The price is unlikely will reverse after that point.
So according to the rules of this strategy, below is an example trade:
We used a 3 to 1 RR but you can adjust according to your rules.
Now we have learned from this Support and Resistance strategy how to draw Zones and how to trade them successfully. We also learned how to determine the direction that the price will probably move to, so we could have a better edge in our trading.
If you liked this strategy or still need more information please leave a comment below and we will answer your questions!
Trading support and resistance, and discovering support and resistance zones are pivotal to your trading success.
Our Fibonacci channel strategy, and the Red zone strategy are very similar and will help you in understanding exactly what these so-called “zones” are as well so you can check them out also if you wish!
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