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Lesson 6: Support and Resistance

Lesson 6: Support and Resistance

Traders will often identify areas of support and resistance to make decisions on trades, including the positioning of stops and limits. Here is a trader's guide to support and resistance lev

Simply put, a support line is where the price of an asset tends to stop falling, and a resistance line is where the price tends to stop rising. But traders really need more information about support and resistance beyond those simple definitions before they attempt to make trading decisions based on those lines (areas) in a chart.

To use the support line and resistance line effectively, you first need to understand how forex or stocks prices typically move, so you can then interpret support and resistance from that framework. You also need to be aware that there are different types of support and resistance, such as minor and major/strong. Minor levels are expected to be broken, while strong levels are more likely to hold and cause the price to move in the other direction.

How to use this guide

  • Learn how to trade using support and resistance levels
  • Open a demo and test the most powerful indicators and strategies
  • When ready, create a live account and leverage your knowledge in the real market

Understanding Support and Resistance

A support or resistance line is a price level that the market has rejected at least twice and is keeping the market from reaching new levels. The support/resistance of an identified level is deemed to be stronger the more times that the price has historically been unable to move beyond it.

Support and resistance levels
Source: CAPEX WebTrader

There could be many reasons as to why the price has been rejected at these levels; accumulation of buy orders (at a support level), or sell orders (at a resistance level); buyers are attracted by the lower levels (support line), or sellers attracted by the higher levels (resistance line); buyers think or feel the market will go higher (support), or sellers think or feel the market will go lower, etc.

Support/resistance is often found at a round price level such as 0.9000 or 1.1000. Many inexperienced traders tend to buy/sell when the price is at a whole number because target prices/stop orders set by retail traders and some large institutional traders are placed at round price levels rather than at prices such as 0.9004 or 1.9234. Because so many stop-loss orders or pending entry orders are placed at the same level, these round numbers tend to act as strong price barriers. Many technical analysis traders will use their identified support and resistance lines to choose strategic entry/exit prices because these areas often represent the prices that are the most influential to an asset’s direction.

3 Simple rules to draw support and resistance levels

  • Rule No. 1: Price needs to get rejected at least twice from the level
  • Rule No. 2: The more rejections the level has, the more important it becomes
  • Rule No. 3: Most recent rejections are more important than less recent rejections

Drawing relevant support and resistance levels can take time, dedication, and practice. You can start with a demo account, where you can put your levels to the test in a risk-free environment.

How to use support and resistance levels

One of the best uses of the support and resistance levels is for entry and exit of positions coupled with an efficient risk management setting. Some of the practical uses include:

  1. Take profit. This is the price at which one takes the profit available on a position. That is, as the price approaches a support line (from above), short sellers may take profits on their positions. Conversely, as the price approaches a resistance line (from below), long traders may take profits.
  2. Establish a new position near an unbroken level. When the price approaches the support levels, a technically driven investor would tend to pitch buy limit orders near and above a defined support and, conversely, would pitch limit sell orders near and just under resistance levels.
  3. Establish a new position on the break of a level. When a support line breaks, one can initiate a short position on the technical expectation that prices will then go onto the next (lower) support level. Conversely, if a resistance line breaks, one could buy on the expectation that prices will move on to the next (higher) resistance line if there is one.
  4. Stop-loss setting. A breach of a level can be used to limit loss too. Rather than using a break of a support or resistance level as an opportunity to establish a new position, you can also use it to minimize loss. A losing position should be immediately exited. The signal to do so comes from the breach of the support or resistance level.

Once broken, support and resistance levels reverse roles. This is a key aspect of the support and resistance level identification: once a level (whether support or resistance) is broken, the technical characteristic of the level is reversed. That is, a broken support now becomes a resistance, and a broken resistance now becomes a support. This can be seen in the figure below.

Support and Resistance example
Source: CAPEX WebTrader

Major and Minor Support and Resistance Levels

Minor support and resistance levels don't hold up. For example, if the price is trending lower, it will make a low, then bounce, and then start to drop again. That low can be marked as a minor support line (area) since the price did stall out and bounce off that level. But since the trend is down, the price is likely to eventually fall through that minor support line without much problem.

Major and minor support and resistance levels
Source: CAPEX WebTrader

Areas of minor support or resistance provide analytical insight and potential trading opportunities. In the example above, if the price does drop below the minor support line, then we know the downtrend is still intact. But if the price stalls and bounces at or near the former low, then a range could be developing. If the price stalls and bounces above the prior low, then we have a higher low and that is an indication of a possible trend change.

Major support and resistance lines (areas) are price levels that have recently caused a trend reversal. If the price was trending higher and then reversed into a downtrend, the price where the reversal took place is a strong resistance line. Where a downtrend ends and an uptrend begins is a strong support line.

When the price comes back to a major support or resistance line, it will often struggle to break through it and move back in the other direction. For example, if the price falls to a strong support line, it will often bounce upward off it. The price may eventually break through it, but typically the price retreats from the level a number of times before doing so.

Top 3 Trading Strategies Based on Support Line and Resistance Levels

The basic trading method for using support and resistance is to buy near support in uptrends or the parts of ranges or chart patterns where prices are moving up and to sell/sell short near resistance in downtrends or the parts of ranges and chart patterns where prices are moving down.

It helps to isolate a longer-term trend, even when trading a range or chart pattern. The trend provides guidance on the direction to trade in. For example, if the trend is down but then a range develops, preference should be given to short selling at range resistance instead of buying at range support. The downtrend lets us know that going short has a better probability of producing a profit than buying. If the trend is up and then a triangle pattern develops, favor buying near support of the triangle pattern.

Buying near support or selling near resistance can pay off, but there is no assurance that the support or resistance will hold. Therefore, consider waiting for some confirmation that the market is still respecting that area.

If buying near support, wait for a consolidation in the support area and then buy when the price breaks above the high of that small consolidation area. When the price makes a move like that, it lets us know the price is still respecting the support area and also that the price is starting to move higher off of support. The same concept applies to selling at resistance. Wait for consolidation near the resistance area, then enter a short trade when the price drops below the low of the small consolidation.

When buying, place a stop loss several pips below the support level, and when shorting, place a stop loss several pips above the resistance level.

If you're waiting for a consolidation, place a stop loss a few pips below the consolidation when buying. When selling, the stop loss goes a few pips above the consolidation.

When entering a trade, have a target price in mind for a profitable exit. If buying near support, consider exiting just before the price reaches a strong resistance level. If shorting at resistance, exit just before the price reaches strong support. You can also exit at minor support and resistance levels. For example, if you're buying at support in a rising trend channel, consider selling at the top of the channel.

In some cases, you may be able to extract more profit if you let a breakout occur, instead of selling at minor support or resistance levels. For example, if you're buying near triangle support within a larger uptrend, you may wish to hold the trade until it breaks through triangle resistance and continues with the uptrend.

There is also a concept that old support can become new resistance or vice versa. This isn't always the case but does tend to work well in very specific conditions, such as a second chance breakout.

Here are the top 3 support and resistance trading strategies:

Range trading

Range trading occurs within the area between support and resistance lines as traders aim to buy at the support line and sell at the resistance level. Note that support and resistance do not always represent perfect lines. Sometimes there will be some noise around, rather than a perfect line. Traders have to identify a trading range – i.e. the areas of support and resistance.

Support and Resistance range
Source: CAPEX WebTrader

Traders are trying to find long entries, when the price bounces off the support line, and are looking for short entries when the price stands near the resistance level. You should also remember that the asset’s price may violate these boundaries, that is why you should consider placing stop-losses below support when going long, and above resistance when going short.

Breakout trading

After a period of uncertainty, the price often breaks out and starts a new trend. Traders usually try to catch these breakouts below the support line and above the resistance line in order to profit on the potential further momentum in one direction.

Support and resistance breakout
Source: CAPEX WebTrader

However, traders shouldn’t act prematurely. For example, the price dropped down below the support line. Many traders rushed to go short immediately. Instead, top forex traders usually wait for the market’s response (a pullback towards support or resistance) to break down before catching a longer downward momentum.

Trendline trading

The trendline trading strategy suggests using a trendline as either support a resistance. Traders simply draw a line, which connects several highs in a downtrend, or several lows in an uptrend. If the trend is strong, the price would bounce off the trendline and continue its movements in the trend’s direction. In this case, traders pick up entry points in the direction of the trend.

Support and resistance - trendlines
Source: CAPEX WebTrader

Top 3 Support and Resistance Indicators

There are many technical indicators in the market for use in forex trading, stock trading, and even cryptocurrency trading. Nowadays many traders have difficulties choosing the relevant ones among so many of them. Most of the time they fail as there are many overrated trading tools and indicators in the market that never show the original results of the indicators. Here are 3 of the most powerful indicators for gauging support and resistance levels.

Fibonacci retracements

Fibonacci is an extremely popular tool among technical traders and is based on the key numbers identified by mathematician Leonardo Fibonacci in the thirteenth century.

Price action traders use the Fibonacci retracement levels as potential support and resistance. Since so many traders watch these same levels and place buy and sell orders on them to enter trades or place stops, the support and resistance levels tend to become a self-fulfilling prophecy. Traders also use the Fibonacci extension levels as profit-taking levels.

Again, since so many traders are watching these levels to place buy and sell orders or to take profits, this tool tends to work often due to self-fulfilling expectations.

>> Learn how to use Fibonacci retracements

Pivot Points

Pivots Points are significant levels chartists can use to determine directional movement and potential support/resistance lines. Pivot Points use the prior period's high, low, and close to estimate future support and resistance levels. In this regard, Pivot Points are predictive or leading indicators. There are at least five different versions of Pivot Points.

Pivot Points were originally used by floor traders to set key levels. Like modern-era day traders, floor traders dealt in a very fast-moving environment with a short-term focus. At the beginning of the trading day, floor traders would look at the previous day's high, low, and close to calculate a Pivot Point for the current trading day. With this Pivot Point as the base, further calculations were used to set support 1, support 2, resistance 1, and resistance 2. These levels would then be used to assist their trading throughout the day.

>> Learn how to use Pivot points

Moving averages

Moving averages can also be used as a dynamic support and resistance level. Traditionally, the 25-day moving average, the 200-day moving average, and the 50-week moving average are the most popular, though they can be slightly altered (for example 21 and 55 respectively to make use of Fibonacci numbers).

Shorter-term Moving Average shows price changes faster than a longer-term Moving Average, while longer-term Moving Averages provide better support/resistance. Shorter duration Moving Averages are less reliable support/resistance than longer ones.

Adapting Trading Decisions to New Support and Resistance Lines

Support and resistance are dynamic, and so your trading decisions based on them must also be dynamic. In an uptrend, the last low and last high are important. If the price makes a lower low, it indicates a potential trend change, but if the price makes a new high, that helps confirm the uptrend. Focus your attention on the support and resistance lines that matter right now. Trends often encounter trouble in strong areas. They may eventually breakthrough, but it often takes time and multiple attempts.

Mark major support and resistance lines on your chart, as they could become relevant again if the price approaches those areas. Delete them once they are no longer relevant—for example if the price breaks through a strong support or resistance area and continues to move well beyond it.

Also, mark the current and relevant minor support and resistance lines on your chart. These will help you analyze the current trends, ranges, and chart patterns. These minor levels lose their relevance quite quickly as new minor support and resistance areas form. Keep drawing the new support and resistance areas and delete support and resistance levels that are no longer relevant because the price has broken through them.

If you're day trading, focus on today and don't get too bogged down with figuring out where support and resistance were on prior days. Trying to look at too much information can easily result in information overload. Pay attention to what is happening now, and mark today's support and resistance lines as they form.

Trading off support and resistance takes lots of practice. Work on isolating trends, ranges, chart patterns, support, and resistance in a demo account. Then practice making trades with targets and stop losses. Only once you are profitable for several months with your support and resistance trading method should you consider trading real money.

Summary

  • A support line is a price level where there are enough buyers to stop the price from falling any further and reverse the price to the upside.
  • A resistance line is a price level where there are enough sellers to stop the price from rising any further and reverse the price to the downside.
  • Support and resistance levels can be easily identified by placing horizontal lines on a chart where the price seems to stop repeatedly.
  • Support and resistance may be drawn using the wicks or the bodies of the Japanese candlesticks, as long as you are consistent in your approach.
  • A support level can become a resistance level and a resistance level can become a support level.
  • Beware of false breakouts where the price seems to break through support or resistance but reverses again in the opposite direction.

Before trading online, you should be aware that the market is susceptible to prominent levels of volatility and as a result, an asset might experience a breakout or breakdown in a short space of time.

As a result, you should carry out both technical and fundamental analyses on the asset you want to trade before you open a position. We also offer educational resources like CAPEX Academy to help you understand trading and get to know the risks.

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