Support and Resistance Trading Guide

Of all tools used in technical analysis, the most basic is the concept of support and resistance. It is so common, that even traders that aren’t necessarily technical by nature are often heard quoting where support or resistance can be found. This is also expressed by the expressions “where buyers are stepping into the market” or conversely, “where sellers are stepping into the market.”

So, what is support and resistance? How can support and resistance levels be determined before the price hits them? How can you use well-determined support and resistance levels as part of a profitable trading strategy? I will answer all these questions below.

Support and Resistance Defined

Starting with support, it is exactly what it sounds like: a spot where the price of a financial instrument is “supported”, or in other words: the pair has trouble getting below a certain price. For example, say you notice that the EUR/CHF currency cross has trouble getting below the 1.20 level. This is support in this pair, and the longer it goes on – the larger the number of traders who then feel comfortable buying at that level. It rapidly becomes a self-fulfilling prophecy at this point, and as such is a good place to think about buying the pair.

Support Level on a Price Chart

Support Level on a Price Chart

Alternatively, there are times when the market cannot seem to break through a price to the upside. In this instance, it is called “resistance”. In other words, the market is resisting price at that point. This runs on the same premise as support, only in reverse. It is simply a place where large amounts of sellers feel that the pair or instrument is overvalued and is willing to speculate that the price is likely to fall. Again, it becomes a self-fulfilling prophecy after enough of these failures to break price. A great example of this was during the 2008 – 2009 markets in the USD/CAD at the 1.30 level.

Resistance in USD/CAD at $1.3000

Resistance in USD/CAD at $1.3000

You must keep in mind that nothing is 100% reliable. Just because price has caused a reaction in previous attempts doesn’t mean it certainly will at the next attempt at a support or resistance level.

Simply put, believers in support and resistance levels speculate that the level will again be significant the next time the price reaches it, and by using these levels, you can increase your odds of success at picking reversals or breakouts.

Increasing the likelihood of your trade working out profitably is essentially what trading is all about and therefore, support and resistance is the essence of Forex trading. Support and resistance are especially important in Forex trading as major currency pairs tend to respect these levels more than other asset classes, except for major cryptocurrencies which probably respect them even more strongly.

Now I’ve established what support and resistance levels are and why they are important, I will explain how to best draw them on a chart. Support and resistance levels are best drawn on a naked price chart (a price chart with no indicators). There are some indicators, such as trend lines or major moving averages, that can act as mobile support and resistance levels, but they can be ambiguous and very challenging for many traders to use effectively.

For these reasons, it is best to start with horizontal price levels. Pull up a naked price chart one or two time frames higher than the timeframe you will trade on. Use the chart’s drawing tools to place horizontal lines at points which you can see to the left of the chart have acted as both effective support and resistance, with only clean runs through that price since.

This is as much of an art as a science and takes some practice. The best way I can show how drawing support and resistance levels is best done is to present a chart with some levels and explain why I drew them.

EUR/USD Support and Resistance 1

My explanation here is about the resistance level indicated by the red horizontal line drawn at $1.13677. If you can understand why I picked that level, you should be able to understand why I drew some of the other levels shown in the price chart, and then be more confident about drawing your own levels on your own price charts. The numbers 1 to 3 below explain what happened at that level the last three times the price reached it, working from left to right.

  1. The price made a lower low, with the real bodies of the structure’s candlesticks capped by $1.13677. The price then broke through this level to the upside with very clean action.

  2. About one week later, the price fell from above to hit this level. It only acted as support very briefly, you can see if you look closely just the first candlestick to touch it had a long lower wick rejecting $1.13677. The price then broke through this level to the downside with very clean action.

  3. The next day, the price rose to test this level from below. It held very precisely, being touched by the “head” in the small bearish head and shoulders pattern which then produced a further drop in price.

You can see here that the last few times the price was hit, it acted for some time as either support or resistance and was then broken cleanly. This is the best technique to use to identify reliable support and resistance levels in Forex, in the sense that they are likely to act again as support or resistance the next time they are reached.

It is important to note that many traders make the mistake of focusing on extreme high and low prices to identify support or resistance levels. This can work but these levels are far less reliable than what I call “flipped” levels, which are also known as “support and resistance role reversal” – levels which have acted as both support and resistance.

Support and Resistance Role Reversal

It is an interesting phenomenon concerning the psychology of support and resistance that it tends to reverse itself when broken, as described above.

What this means, simply put, is that a level that is broken through will often act as support later. The same is true of support that gives way - it will often act as resistance later. One especially easy way to think of this is like you would a high-rise building: If you are on the first floor, the ceiling (resistance) keeps you from getting to the second floor. However, if you go around the ceiling via the stairs, you are now on the second floor. That same plane that was your ceiling is now the floor, and is supporting your weight, keeping you from falling back to the first floor. Naturally, this works in both directions.

Stairstep Support and Resistance Levels

Stairstep Support and Resistance Levels

As with all things related to technical analysis, the higher the time frame the more reliable something is. This is especially true with support and resistance. You will often see charts where traders talk about support and resistance on short-term charts. Remember, it takes much more in the way of trades to make a support or resistance level appear on the weekly time frame than it does a 15-minute chart, and such a trend may be a stronger indicator of where to trade profitably. You should always draw support and resistance levels on a higher timeframe than the timeframe you are using to identify trade entries.

Can Indicators Identify Support and Resistance?

As the importance of these levels is widely regarded as a major key to profitable Forex trading, several claims are made how best to identify them. One common claim is that round/whole numbers, “key” moving averages, trendlines, pivot points, and other derivative indicators tend to act as effective support and resistance levels. I have reviewed a lot of historical price charts and have never been able to construct a single statistically valid Forex back test showing that these indicators are any better than drawing random lines.

Sometimes a similar but weaker claim is made that when these indicators are confluent with more intelligently identified support and resistance levels, the levels are strengthened and made more valid. Although my intuition agrees with this, when I test it, I cannot prove it. I took a profitable back test of a Forex trend following strategy conducted over thousands of trade samples spanning more than a decade, that bought on reversals from rejections of lows at the previous X candlesticks and filtered the results by proximity to whole / round numbers. The positive expectancy per trade was unchanged. I did another filter of the results, checking whether trading only when the rejections were close to recent daily, weekly, or monthly high and low prices, or at pivot points. Again, the performance of the strategy was completely unchanged. I have no doubt that if key moving averages were tested in the same way, they would also fail to produce better results.

What about trend lines? These can work, especially when two trend lines begin to form and between them make a symmetrical channel. The best trend lines are obvious, sharp, and long-term. Unfortunately, many trend lines generate ambiguities, so more ambiguous trend lines should only be attempted as support or resistance when the higher time frame chart’s context supports a trade in that same direction.

 I do not believe there is any derivative indicator that can provide a trading edge by identifying support and resistnace levels, although there are some that can identify reversals by immediate price action. The bottom line on identifying support and resistance levels: do not expect to get an edge from any formulaic, quantitative approach. You must know how to read a price chart intelligently and consider the prevailing conditions at the time the level is hit to use support and resistance successfully.

For example, say 1.1000 looks good as probable resistance, as the price topped there a few days back and has continued to fail to make new highs. Then news is released that a relevant central bank has changed its interest rate and the price is driven up to 1.1000, but this level is unlikely to mean much in the new market condition.

Prime Conditions for Support and Resistance Levels to Hold

The best time to think about waiting for support and resistance levels to be hit is when the price has been going sideways for a longer period than when it was most recently going up or down.

Price Chart Showing Ranging Conditions with Support and Resistance Levels

Price Chart Showing Ranging Conditions with Support and Resistance Levels

Many traders tend to make the understandable mistake of relying too much on finding support levels in an uptrend and resistance levels in a downtrend. There is nothing wrong with that, but you don’t want to be sitting out a strong trend without taking any trades just because the pullbacks never reach your targeted levels.

Do Support and Resistance Levels Really Matter Anyway?

I mentioned previously that by following trends, it is perfectly possible to make money without ever thinking about support and resistance levels. If you have ever wanted to take a trade but felt that you were trading into a support or resistance levels, only to watch the price later shooting past the level without you, then you will know what I am talking about.

Traders searching for a better way to approach Forex should consider whether they are relying too heavily upon support and resistance. Such an over-reliance can lead to too much counter-trend trading and missing out on good trades. Most of the best Forex trades available do not begin as reversals from well-defined support and resistance levels, and that’s something worth thinking about.

Trade the Top 4 Support and Resistance Trading Strategies

The advantage of developing the skill of drawing likely support and resistance levels on a price chart is that it can give a basis for several profitable trading strategies, or at least an element that can be added to a good trading strategy.

Here are the top 4 support and resistance strategies:

Grid Trading Strategy

A grid trading strategy works by taking a long-term price chart and dividing it into horizontal zones away from the current price, which acts as a center line. When the price reaches the dividing levels, you open a trade in the direction back towards the center line. Many grid traders just divide the price chart’s range up equally with a few horizontal lines and use these as trade entry points. However, when you can identify likely support and resistance horizontal levels, you can place the dividing levels more intelligently.

A great thing about grid trading is that you can use it to adapt to changing price action and follow a weak or very gently developing trend, either by only opening trades in one direction, or by being quicker to exit counter trend entries.

Range Trading Strategy

There are times where the price consolidates over the course of a few days, and a clear range is established with the price just oscillating between the two extremes, or close to them. This condition is quite common in all markets and especially in the Forex market. In a range trading strategy, you hope that the range continues to hold.

Entries and exits can be very simple: place a long limit order at the support with its take profit at the resistance, and a short limit order at the resistance with its take profit at the support. Then sit back and wait for the levels to be reached by the price. A very key element in this strategy is placing the stop loss, which can be challenging. A simple strategy that can be used profitably for stop loss placement here is to use a fraction of the size of the range, such as half or one quarter. For example, if you are trading a range of 80 pips, you could enter a stop loss of 40 or 20 pips.

An alternative strategy can be used where you wait for the price to hit support or resistance and closely watch the price action on a short time frame to see whether there seems to be a clear rejection and reversal. If there is, you then enter with a market order. You could also use the price action to determine when to exit if the price gets near to the support or resistance level at the other edge of the range.

Once the range has been decisively broken, you should stop using the strategy because strongly ranging technical conditions have seemingly ended.

Buy the Dips Strategy

This is the same as the grid trading strategy, except you enter trades only in the direction of the trend. This is a trend trading strategy so a variety of exit strategies can be used profitably. As in the range trading strategy, you can enter either by limit orders at the key levels, or by watching the price action when the level is first reached and deciding upon entry if the action looks like a strong reversal.

Confirmed Breakout Strategy

All breakout trading strategies use the price breaking past support or resistance as an entry signal. Therefore, the success rate of any breakout trading strategy can be improved by using a method which tells you whether the support or resistance you are using as a breakout level has been truly broken or whether it will soon start to hold again. There are two major methods you can use to filter breakouts like this:

  1. Wait for a candlestick to close beyond the breakout level. For example, if you are looking to trade a breakout above $1.1000, instead of just putting a buy stop order at $1.1001, you can wait for the price to get above $1.1000 and wait some time to see if the price remains above that level. This can be done by waiting for the close of a candlestick, with more conservative approaches waiting for longer periods of time. Of course, if you want too long you might miss most of the break. Yet it is true that the longer the price holds beyond a breakout level, the greater the chance of it being a true breakout that is likely to continue going in the same direction.

  2. After the breakout happens and the price goes some distance beyond the breakout level, wait for the price to retrace and fall back to the breakout level. If the level which was formerly resistance now starts to hold as support, this is a classic and powerful sign that you are more likely to have a true breakout happening. Using this method can give you a very tight entry with a great reward to risk ratio. However, it may be that the retracement never makes it back to the breakout level after the breakout, so you will miss some trades.

Final Thoughts

Understanding support and resistance and being able to forecast price levels where there is likely to be support or resistance when price next gets there, are very useful skills to have in Forex trading. Support and resistance are an especially important concept in Forex trading because the major Forex pairs often reverse direction at key price levels, sometimes because big banks have huge Forex options with strike prices at these levels, so they are prepared to spend money in the spot Forex market defending them.

The most reliable support and resistance levels are those which acted as both support and resistance in the past before it was cleanly broken. Accurately identifying reliable support and resistance levels can give you very attractive Forex trade entry opportunities with high reward to risk ratios. Support and resistance can be used as a building block within almost any type of trading strategy, whether it is a trend or momentum type of strategy, or a range trading strategy.

When you use support and resistance levels in trading, remember that you do not have to enter or exit trades as soon as the price reaches the key levels which you have identified on a chart. You can instead wait for some time to watch how the price reacts at the level and whether it prints any candlestick patterns before deciding on an entry or exit. The longer you trade and the more you practice, the better you will likely become at making these calls based on price action.

FAQs

What is the difference between support and resistance?

Support is a price level which the price is unable to fall below, while resistance is a price level which the price is unable to rise above. They are essentially the same phenomenon facing in different directions.

What is a support and resistance strategy?

A support and resistance trading strategy are one that relies at least partially upon identifying price levels which are likely to be supportive or resistant, and entering or exiting trades at or close to these levels appropriately.

How to find support and resistance levels?

The best way to find support and resistance levels is to look for prices which have recently acted successfully as both resistance and support.

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.
Learn more from Adam in his free lessons at FX Academy

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