Support and Resistance
Support levels and resistance levels are incredibly useful tools for traders conducting technical analysis. They indicate levels of supply and demand, and when broken, serve as guidelines to establish how supply and demand have changed, and new levels of support and resistance are created. On a typical technical analysis, support and resistance levels are indicated by two paired, parallel lines, with the lower line indicating support, and the higher line indicating resistance. They serve as crucial indicators of a market’s psychological mood.
Defining Support and Resistance Levels
Let’s take a look at the two levels in detail, starting with support. Support is the level where demand is strong enough to keep a currency’s price from falling further. For example, a stock may touch a lower low, but be unable to break it, and as a result, subsequent trades will only be able to match or be higher than the low. The reason this behavior takes place is that as the price drops and approaches the support levels, buyers (who set the demand) become more willing to buy, while sellers (who set supply) become less willing to sell.
As support shows the demand side of a given market trend, resistance shows the opposite, supply. Resistance is the level where supply is strong enough to keep the price from moving past it. Every time a price reaches a resistance level, it no longer falls, but instead stays at that level or, usually, adjusts a bit higher. This is because as the price goes up (meeting the resistance level), the sellers (who set supply) have more incentive to sell, while buyers (who set demand) are less willing to buy.
To summarize, support levels indicate demand and set a lower boundary on a price falling further, because buyers are more willing to buy at that price. Resistance levels indicate supply and set a higher boundary on a price rising higher because sellers are more willing to sell that price, while buyers are wary of buying higher. The following chart demonstrates support and resistance levels - Support levels are indicated in blue, while resistance levels are indicated in red.
Using Support and Resistance In Trading
One of the basic ways to use support and resistance levels in trading involves buying near support during an uptrend (when the price is generally moving up), and short-selling near resistance during downtrends (when the price is generally falling.) However, keep in mind that while buying near support and selling near resistance can sometimes work, there’s no guarantee that these levels will stay unbroken. It’s always a good idea to wait at least a little while, until there are three or so data points, to confirm that there’s a lessened risk of a break.
If you do buy near support, then try waiting for the prices to consolidate, and then buy when the price rises above the consolidation. Prices moving like that indicate that the support is still being respected while moving higher. Selling near resistance works similarly - wait for consolidation, then short when the price drops below the consolidation. Also, remember to set a stop loss a little below support when buying, and a little above resistance when shorting, and, if you’re waiting for consolidation when buying, place a stop loss a bit below consolidation, and a bit above when selling.