One of the most commonly used trading ideas is “support and resistance.”
Surprisingly, everyone seems to have their own sense of how to assess support and resistance.
Let’s start with the fundamentals.
Take a look at the diagram above. As you can see, the zigzag pattern is rising (a “bull market”).
When the price rises and then falls, the highest point reached before the fall becomes resistance. Resistance levels suggest areas where there will be an overabundance of sellers.
When the price rises again, the lowest point hit before the decline becomes support. Support levels suggest areas where there will be an overabundance of buyers.
As the price swings up and down over time, resistance and support are constantly established.
The reverse is true during a downtrend.
In the most basic way, this is how support and resistance are normally traded:
Trade the “Bounce”
- Buy when the price falls towards support.
- Sell when the price rises towards resistance.
Trade the “Break“
- Buy when the price breaks up through resistance.
- Sell when the price breaks down through support.
Plotting Support and Resistance Levels
Keep in mind that support and resistance levels are not exact numbers.
Frequently, you will notice a support or resistance level that appears to be breached, only to discover that the market was only testing it.
These “testing” of support and resistance are typically depicted by candlestick shadows on candlestick charts.
Take note of how the candle shadows tested the 1.4700 support level.
At the moment, it appeared as if the price was “busting” support.
With the benefit of hindsight, we can see that the price was simply testing that level.
How can we be certain that support and resistance were broken?
This question has no definitive answer.
Some say that a support or resistance level is broken if the price can close above or below it.
This is not always the case, as you shall see.
Take our last example and see what happened when the price actually closed above the 1.4700 support level.
In this scenario, the price fell below the 1.4700 support level before recovering back above it.
If you had thought this was a true breakout and sold this pair, you would have been in big trouble!
Looking at the chart presently, you can observe and conclude that the support was not broken; it is still very much intact and has become much stronger.
Support was “breached,” but only temporarily.
To assist you filter out false breakouts, consider support and resistance as “zones” rather than precise figures.
Plotting support and resistance on a line chart rather than a candlestick chart can help you discover these zones.
The reason for this is that line charts only display the closing price, whereas candlestick charts include extreme highs and lows.
These highs and lows might be deceptive because they are frequently the market’s “knee-jerk” reactions.
When plotting support and resistance, you don’t want the reflexes of the market. You only want to plot its intentional movements.
Looking at the line chart, you want to plot your support and resistance lines around areas where you can see the price forming several peaks or valleys.
Other Interesting Tidbits about Support and Resistance:
1. When the price passes through resistance, that resistance could potentially become support.
2. The more often price tests a level of resistance or support without breaking it, the stronger the area of resistance or support is.
3. When a support or resistance level breaks, the strength of the follow-through move depends on how strongly the broken support or resistance had been holding.
With a little practice, you’ll be able to spot potential forex support and resistance areas easily.
Next Lesson: What are Trend Lines?