Forex Trading - Support And Resistance

The concepts of support and resistance are undoubtedly two of the most highly discussed attributes of technical analysis and they are often regarded as one of the most important concepts in Forex trading. These terms are used by traders to refer to price levels on charts that tend to act as barriers from preventing the price of an asset from getting pushed in a certain direction. At first the explanation and idea behind identifying these levels seems easy, but as you'll find out, support and resistance can come in various forms and it is much more difficult to master than it first appears.



What is Support?

A support level is a price level where the price tends to find support as it is going down. This means the price is more likely to "bounce" off this level rather than break through it. However, once the price has passed this level, by an amount exceeding some noise, it is likely to continue dropping until it finds another support level. Support does not always hold and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.



What is Resistance?

A resistance level is the opposite of a support level. It is where the price tends to find resistance as it is going up. This means the price is more likely to "bounce" off this level rather than break through it. However, once the price has passed this level, by an amount exceeding some noise, it is likely that it will continue rising until it finds another resistance level. Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.



Testing the Levels

One thing you should remember is that levels of support and resistance are not always accurate figures. You will often see a support or resistance level that seems to be broken, but soon you will realize that the market was only testing it. On candlestick charts those tests are marked with shadows as you can see on the picture below. It seemed as if the market will pass the resistance level, but later it was obvious that it was just a test. There is no easy way of knowing if the resistance or support will be broken through.

Support Equals Resistance

Another principle of technical analysis stipulates that support can turn into resistance and vice versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance.

The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support will be found.

Trading Range

Trading ranges can play an important role in determining support and resistance as turning points or as continuation patterns. A trading range is a period of time when prices move within a relatively tight range. This signals that the forces of supply and demand are evenly balanced. When the price breaks out of the trading range, above or below, it signals that a winner has emerged. A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply).

Support and Resistance Zones

Because technical analysis is not an exact science, it is useful to create support and resistance zones. Each security has its own characteristics, and analysis should reflect the intricacies of the security. Sometimes, exact support and resistance levels are best, and, sometimes, zones work better. Generally, the tighter the range, the more exact the level. If the trading range spans less than 2 months and the price range is relatively tight, then more exact support and resistance levels are best suited. If a trading range spans many months and the price range is relatively large, then it is best to use support and resistance zones. These are only meant as general guidelines, and each trading range should be judged on its own merits.

Trend Lines

Trend lines are probably the most common form of technical analysis that is used today, but they are also one of the least-used. A trend line is formed when you can draw a diagonal line between two or more price pivot points. They are commonly used to judge entry and exit investment timing when trading securities.

A trend line is a bounding line for the price movement of a security. A support trend line is formed when a securities price decreases and then rebounds at a pivot point that aligns with at least two previous support pivot points. Similarly a resistance trend line is formed when a securities price increases and then rebounds at a pivot point that aligns with at least two previous resistance pivot points.

If they are drawn accurately, trend lines can be a very useful and precise technical analysis method. Unfortunately, most of the Forex traders don’t draw them correctly or try to draw a line in a way that the lines correspond to the market, instead of making it the other way around.

The support or resistance of an identified level, whether discovered with a trend line 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 or exit prices 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.



Round Numbers

Another common characteristic of support or resistance is that an asset's price may have a difficult time moving beyond a round price level. 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. 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 , it would take an extreme number of purchases to absorb these sales and, therefore, a level of resistance would be created.

Conclusion

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 because it signifies 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 or resistance, but regardless of the method, the interpretation remains the same - it prevents the price of an underlying from moving in a certain direction.