Trading is not a simple business…
Many traders have issues identifying support and resistance (S-R) lines, let alone knowing how to use them in active trades.
Support and resistance zones/lines show price areas where buyers and sellers use as entries and exits. They are therefore very important trading tools in forex and this article will aim to show how to identify S-R lines as well as use them in active trades.
It’s easier than you think.
Definition of Support and Resistance
What is a support?
A support is a zone or area on the chart where the price of an asset finds it difficult to move below or a line/area where the asset price has bounced on in the recent past. A support can also be referred to as a key area on the chart where buyers are more likely to buy an asset and sellers are more likely to exit their positions on the asset.
When selling interest cools off and buying interest takes over, prices will take a break from their initial downward movement to form a support.
What is a resistance?
A resistance is a zone or area on the chart where the price of an asset finds it difficult to go above or an area where uptrending prices have retreated in the recent past. The resistance can also be described as an area where traders are more likely to exit their long positions and assume short positions.
When buying interest cools off and sellers take over the market, prices will take a break from the uptrending action, leaving the price high to form a resistance.
There are three ways we can define support and resistance:
- Determine Support and resistance areas using psychologically points.
- Determine Support and resistance areas using indicators such as pivot points and Fibonacci levels.
- There are also price action tools used in determining support/resistance. These tools could be chart patterns or candlestick patterns.
1. Psychological Support and Resistance
Traders sometimes use price levels that end up as round numbers as their exit targets. These round figures then form support and resistance areas when there are enough of those targets to form great offer demands around those numbers. This is why these areas are referred to as psychological support/resistance areas.
Why is that?
Round figures refer to prices which typically end with zeros such as 1.2800, 76.00, 52.00, 1.8900, etc. These are not usually very reliable areas of support and resistance because there is no way for the trader to accurately gauge whether an offer demand has formed in sufficient quantity to cause those price areas to hold.
2. Indicator-Based Support and Resistance
Indicators can also be used as a basis for support and resistance. Two very good indicators that make themselves amenable to this are the pivot point indicators and the Fibonacci retracement tool.
The pivot point indicators are any custom indicators that are able to trace the daily, weekly or monthly pivot support/resistance points on the charts. Usually, we calculate pivot points using the price data of the high, low and closing prices from the previous day’s trading. With these data, seven DAILY pivot points are derived: a central pivot (shown on the charts below in purple), three support pivots (shown in green) and three resistance pivots (shown in red).
The pivots do not behave as they are strictly described:
depending on the price action, a resistance pivot may function as a support and a support pivot may act as a resistance. In both situations, this usually occurs following a breakout and an attempted pullback of price action to the broken pivots.
This chart above shows the pivot points as plotted by a pivot point calculator.
The Fibonacci retracement tool draws up to 5 levels to which a trending price can retrace to, thus providing valid areas of support and resistance. However, the use of the Fibonacci retracement tool is best left for experts.
3. Price action S-R Lines
We can determine price action also according to where support and resistance occur.
If a particular price level has functioned as a support or resistance level in the recent past, it is likely that traders will respect those levels when prices approach them, as the sentiment at the time may indicate a recent support as an oversold area, or a recent resistance as an overbought area.
Price action forming support and resistance areas
The chart above shows areas where support and resistance were formed by the price action as depicted by the candlesticks.
We can use these trend lines to delineate price lows and price highs, and when superimposed on a chart which already has indicator-based support and resistance tools such as the pivot point indicator, they can provide a very sound basis for trading S-R lines.
It is important for traders to understand how to determine support and resistance lines. We discuss it in the next section.
Identification of S-R Areas
Three key points are crucial in an identification of S-R areas as well as in defining the quality of the S-R lines.
- The more points on a support/resistance line are touched by price action, the stronger the S-R lines are, and the better the quality of the S-R lines. Therefore, a support or resistance line that has been touched at least 4 times, is stronger and of better quality than one which has been touched only twice by the price action.
- Longer time frame charts provide better quality and stronger S-R lines. It is preferable to trade with an S-R line on a daily chart, then the S-R lines on 15 minute charts.
Lower quality S-R lines produce higher risk. Higher quality S-R lines produce lower risk, but may result in many missed opportunities. It is an experience that will help a trader to balance the risk and opportunity for each setup.
1. Identifying Psychological Support/Resistance Areas
Identifying areas of psychological support and resistance can be done if those areas have held firmly recently. If the trader sees that these round figure price areas have not been tested previously, they should not be used for trading.
2. Pivot points
The designers of pivot point indicators have made it very easy for traders. There is no need to manually calculate these levels. Rather, the pivot point S-R levels are drawn and color-coded on the charts. The chart above shows this very clearly.
3. Price action S-R Levels
Detection of support and resistance areas formed by price action requires the use of trend lines to delineate the price lows (support) and price highs (resistance). You should test each area multiple times to qualify to be drawn off with trend lines.
How to Use Support and Resistance Lines to Trade
The idea of using support and resistance lines is to identify areas where there is a pullback and continuation of price action within the context of a trend, as price action navigates its way between a support and resistance line. In this example, we will use pivot points as well as candle patterns to identify trade entry and exit points.
Take a look at the chart above, which shows three areas of support, three areas of resistance and a central pivot.
The price action on the left sweeps through the various pivots, finds some kind of support on S1, then pushes upwards to find resistance at R3 (breaking R2 along the way with a brief pullback to R2), makes a run downwards to find a brief support at S1, then another upward run to the central pivot.
Fig1a: Support and resistance plotted with pivot point calculator
A broken pivot point changes its role.
For instance, if a price move to the south breaks below the S2 support and tries to reach again for S2, S2 in this case no longer functions as a support but as a resistance.
See chart below:
Break of pivot points and implication for support and resistance
If you want to use the support and resistance lines formed by the pivot points for trading, the logical trade is to allow for a break of a pivot line, followed by a pullback to the broken pivot, where we can use a limit order in the direction of the initial move.
If the pivot line is not broken (i.e. the candle does not close above a resistance line, or does not close below a support line), we can make the logical trade as a reversal trade. This setup is best traded within the context of ranging prices.
B. Price action support/resistance
Using trend lines, support and resistance areas can be cordoned off from the price lows and price highs respectively. Support and resistance are areas of potential breakout and continuation, or potential reversal.
Candlestick Patterns To use in Support Trading And Resistance Reversals
Support and resistance are areas of potential breakout and continuation, or potential reversal. In trading potential reversals, reversal candlestick patterns can be used as adjunctive tools to take the trades. The following candlestick patterns can be used to trade support and resistance reversals:
- Engulfing patterns
- Doji star patterns (morning and evening)
There are others but these are the commonest and easiest to identify on the charts.
The chart above shows the various candlestick patterns that created reversals at various points of support and resistance. Here’s another example:
Support and resistance levels are the backbone of most forex trading strategies. Many traders use them to trade continuations or to trade reversals. The trader should do some in-depth study of how to identify these areas and how to use them to trade.