Setting Stop Losses and Take Profits With Support and Resistance
One of the common uses for support and resistance levels is to rely on them to indicate where you should be placing your stops and take profits. After all, it makes sense to let the market guide your decisions, considering we’re trading on them. Let’s say that you’ve been tracking a currency pair, and you notice that there’s about to be a breakout - that is, the price movements are going above the resistance. You want to take advantage of the situation, so there are a few things to consider: Firstly, you need to determine where to set your stop loss, and secondly if your instinct turns out to be wrong, what conditions could you use to determine that?
A good rule of thumb is to set your stops at support since if the price falls to consolidate at the break and fall back to the resistance, you now know that there was no demand at that price and that supply is growing. On the other hand, if your original trade idea was right, then you stand to turn a tidy profit if you’ve gone long. Your take profits should rely on the same principles in a downtrend - set the take-profit at a support when shorting, so that you can start hitting profit targets without risking too much if the market suddenly moves against you.
Exhibit 3: Turning Points
Determining support and resistance is largely a determination of turning points. Turning points tell us when the market goes from bull to bear, or from growth to fall. To find a turning point, pay attention to prices moving in one direction or the other - on a candlestick chart, this can be seen after at least two candlesticks moving in a given direction.
For example, a candlestick chart showing two bullish and two bearish candlesticks can indicate a turning point from rising to falling. Once you’ve found the turning point, you can now wait and see if the price is going to be tested - four or five points is enough to establish whether a level has formed.
The Psychology of Support and Resistance
Support and resistance levels are not mathematical certainties - instead, they define psychological breakpoints. To illustrate what that means, let’s take a look at several examples of how support levels are formed.
Example 1: Buying Near Support
Let’s say that we have a demand area at a support level for a given pair. That level is set at $100. Buyers buy at $100, pushing the price higher, to $110. While buyers are happy, they don’t want to buy at $110, instead, they want to continue buying at $100. If the price moves down to $100, they’ll continue buying, otherwise, they’ll wait. Thus, the buyers are creating demand at the support level.
Example 2: Regret
Let’s take the same situation as above, but this time, let’s say that our buyers didn’t manage to buy at $100 - they were uncommitted, and missed out on the opportunity as the price hit $110. Now, they experience regret, that is, they regret not buying at $100. In order to not make the same mistake, they commit to buying at $100, creating additional demand at $100. This experience of regret sets a psychologically determined level of support at $100.
Example 3: Sellers into Buyers
The situation is the same as described above, but with a caveat. Let’s say that instead of buying at $100, our buyers bought at $90, selling at $100, only to see it rise to $110. They’ve missed out on the rise, and regret selling so early. Again, they now commit to buying at the same price they’ve sold, $100, again creating demand at the $100 support level.
Example 4: Resistance
We’ve seen how different trading situations can create psychological support levels, but what about resistance? Well, the formation is similar. Let’s say that our traders all have open positions at $100. They see a jump to $110, but hold off on selling, expecting the price to rise again. When it falls to support, what do you think they experience?
It’s a good bet to assume that our traders will now feel regret for not selling at $110, so they commit to not miss that opportunity again. When the price bounces back to $110, they close out their positions. But since, they’ve all done that, the price has downward pressure, as there’s more supply than demand. That means that $110 is now a supply ceiling, or in other words, a resistance level.
These examples are probably familiar to you if you’ve traded before, and you can probably empathize and model the feelings of all the participating traders. The aggregate emotions and feelings of market participants can be referred to as market psychology, and it is one of the driving factors behind support and resistance levels.