Support and Resistance Explained | FXTRADING.com - International

Support and Resistance Explained

Admin, August 20th, 2020

Support and resistance levels are an important yet relatively simple tool in a trader’s toolbox. We discuss what they are, how to identify them and how to use them.

Some argue you can trade purely from support and resistance (S/R) levels, whilst others would urge you to implement other forms of analysis with support and resistance to find an edge. Either way, most would agree that it helps to at least be able to identify these key levels to plan your trading around them.

What are Support and Resistance Levels?
Support and resistance refers to key areas or levels on a price chart which usually have historical relevance. That is price action (for whatever reason) has stalled or reversed at a particular point on a chart to show that there is support (demand) or resistance (supply) at such a level.

We can think of support as a floor in a building and resistance as a ceiling. Therefore, if falling prices hit a ‘floor’ which causes the decline to stall or rebound, it has found a level of support. Whereas if rising prices hit a ‘ceiling’ and so they stall or revert lower, a level of resistance has been formed.

How are Support and Resistance Levels Formed?
There are be a number of reasons as to why a price reversal might occur at a particular level to form a support or resistance level, but the most rounded answer we can give is to say “there are more buyers than sells” or “more sellers than buyers” at a given point in time.

Whilst this may not seem profound, it should be remembered that at any one time a trader has only three options:

  1. Buy (buy long)
  2. Sell (sell short)
  3. Stand aside (keep out)

It is the dynamic between these three options which drives prices higher and lower. And it is the sudden shift in sentiment to favour bulls or bears as any given point which makes prices reverse to respect a key level. But if this level is respected enough, it can create a feedback loop which reinforces the strength of the S/R level.

A way of viewing support and resistance is to think that price action has a memory, particularly when an event has a storey or milestone behind it such as:

  • Surprise events such as a ‘flash crash’
  • All-time highs and lows
  • Previous session highs / lows, previous week’s high’s lows, previous month etc.

What can typically happen when price action revisits a ‘historical event’ or milestone is that the move hesitates or pauses or reverses around the key level. This is because traders are watching this key level as price action approaches and adjusting their stance, whether it be to initiate a long or short position, or simply exit.  This effectively means that a feedback loop among market participants is causing price action to move towards or away from key levels they are watching.

Historical Support and Resistance are Generally More Significant
Whilst we just explained how prices form a level of support or resistance, what traders are looking out for are historical levels of support and resistance. By this we mean where prices have shown a tendency to pause or reverse at a key level or zone on multiple occasions. These levels can appear on any timeframe but the longer back in history they go, or the bigger the headline behind it, the more significant the S/R level is deemed to be. The EUR/GBP chart above is an excellent example of this, as it shows a multi-year level of support following a significant news event.

Yet if after multiple attempts we finally see a significant historical level of support or resistance break, the larger the next more may potentially be. This is by no means a hard and fast rule, but a good rule of thumb to follow.

Support Can Become Resistance (and Resistance Can Become Support)
When a S/R level breaks it is not uncommon to see price action retrace towards the breakout level and pause. For example, a bearish break of support could see prices retreat higher and turn prior support into resistance. Conversely a bullish break of a resistance level can sometimes see prices retrace lower and find support around the original resistance level. In fact, many traders look out for this exact scenario to plan their trades around.

Once a level of support has turned into resistance, or resistance turned into support, it can be referred to as a ‘pivotal level’. (Not to be confused with pivot points which we will cover in greater depth in a later article).

How to Identify Support and Resistance
As with any chart, the best place to start is by looking at price action. From there you can add indicators and blend ideas together to come up with zones of support and resistance that you suspect will be a high probability area for prices to pause or reverse.

With that said, here are some of the more obvious places to identify S/R levels. The list is in no way exhaustive but will provide a logical approach to identifying key levels.

Swing Points and a Moving Average Acting as Resistance
Swing points on a chart are supposedly the most watched area on a chart by market participants. It therefore make sense for you to monitor them to as they are high probability areas of S/R. Moving average also make good ‘dynamic’ S/R, although like all methods they can fail and some markets tend to like other lengths of average than others. As we can see above, the 60-period eMA is not a typical length used but it worked during this uptrend.

Trendlines Provide S/R
Whilst S/R are usually horizontal levels, trendlines and moving averages are the exception. Notice how it as resistance before pulling back and finally breaking (as market participants were clearly watching this trendline).

Flash crash / Spike Providing Support
Flash crashes do not happen often but they are an aggressive form of spike which can also act as a level of S/R if revisited. Granted, in this example there was a lot of noise around the spike low and several failed attempts to break beneath it, but it does show how traders do watch these key levels.

What can happen if S/R breaks?
When a level of S/R breaks, the next question then becomes whether or not the level will remain broken. Going back to our ‘three trading decisions’ (buy, sell, stand aside), traders will be frantically deciding which group to be in after the level has broken. Again, the dynamic between these groups has shifted with a breakout, and we need to wait until bulls or bears are back in control before finding out if the breakout is successful.

At this stage there is one of three scenarios to look out for.

  1. Price action continues in the same direction of the breakout from S/R
  2. The breakout becomes a failure, prices reverse and go back over the original S/R level
  3. A battle between bulls and bears ensues, causing prices to pause or ricochet until bulls or bears take control


Trading the breakout:
If an S/R level can be broken with enough force, it can sometimes produce a sizeable move in the direction of the breakout. Part of the reasoning here is that it is generally assumed that large stop losses (stops) reside on the opposite side of an S/R level to where price action currently trades.

For example, large stops can sometimes be found beneath key levels of support or above a key level of resistance. If large traders are confident a level of S/R will hold, they might place their large stops beyond the key level of S/R. Yet if the key level breaks and triggers their large stops it essentially adds fuel to the fire of the breakout. This is important to understand because when large stops are triggered it can extend a move in the direction of the breakout.

Breakout traders would have likely already identified the key level in question which, if broken, they wish to enter a trade in the direction of the breakout (eg. They could enter short trades for a breakout from support or long trades for breakout above resistance).

View our article on Order Types Within MT4 for further information

  • A trader could use a ‘pending order’ for a ‘set and forget’ trade to enter if the market breaks a key level. The advantage with this approach is the trader doesn’t need to monitor the markets to set the order. The disadvantage is their order may trigger at an undesirable level if the market gaps against them.
  • Alternatively, they could use a market order to enter live at market, once the breakout has occurred. This allows the trader to use their discretion on whether the breakout appears to be legitimate, whilst also allowing them to step aside if the breakout gaps and the prices have ‘gone without them’.
  • Both approaches remain at risk of being a losing trade if prices reverse against them.

 

Trading the ‘fakeout’
A ‘fakeout’ refers to a failed breakout. Also called a bull-trap or a bear-trap, it simply means the original breakout reversed back over the original breakout level.

If a breakout occurs, some traders will wait to see if prices retest the breakout level, or pullback closer to it before the momentum for the breakout resumes. And as breakout and fakeout trading is not for everyone, waiting for a pullback is a viable option for a more conservative approach.

In the example above, an opportunity to go long occurred after prices broke back above the original support level (following the bullish hammer) then retraced back towards support. Whilst price action did not perfectly retest support, it retraced close enough for a tradable opportunity.

Under this scenario a trader has two methods to enter.

  1. Use their discretion and enter live at market when they felt the low was in place
  2. Set a ‘buy-limit’ order above support to ‘catch’ the retracement

 

Trading the Pullback

As mentioned, once a level of S/R breaks, prices can revert towards the breakout level. In turn this provides an opportunity to trade in the direction of the breakout.

Here we have a textbook example where prices almost perfectly retraced into resistance (former support) and formed a bear flag before breaking lower again.

As before there are two approaches a trader could consider:

  1. Enter live at market below resistance, assuming the level will not break
  2. Or use a sell-limit order (set and forget) somewhere above current price action but beneath the S/R level.

Naturally any one of these setups could have failed and resulted in a loss, which is why sensible risk management is key. But hopefully the above examples provide enough to show you the theory of how to identify and consider trading around levels of support and resistance.

 

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