Technical analysis is built on two foundational concepts: support and resistance. Understanding what these terms mean and how to use them is critical for correctly reading price charts.
Prices move as a result of supply and demand. When demand exceeds supply, prices rise. Prices fall when supply exceeds demand. Prices will sometimes move sideways when supply and demand are in equilibrium.
Like many in technical analysis, the explanation and rationale underlying technical concepts are relatively simple, but mastering their application frequently takes years of practice.
In this article, we will learn some basic concepts of support and resistance and how to draw them manually.
Prices fall during a downtrend because there is an excess of supply over demand. The lower the prices fall, the more appealing the prices become to individuals waiting to buy shares or a particular currency. Demand, which would have been gradually increasing, would eventually catch up with supply. Prices will cease declining at this point. This is called support.
Support can be a price level or a price zone on the chart. In any case, support is a price chart area that indicates buyers’ willingness to buy. At this level, demand usually outstrips supply, causing the price decrease to overwhelm to a halt and reverse.
Support is the polar opposite of resistance. Prices move when there is more demand than supply. As prices move upward, there will come the point when selling overwhelms the impulse to buy. This can happen for a variety of reasons. Traders may have judged that prices are too high or that they have reached their aim.
It might be the unwillingness of purchasers to initiate new positions at such rich valuations. It might be for a variety of reasons. A technical, on the other hand, will easily observe the level at which supply overwhelms demand on a price chart. This is called resistance. It might be a level or a zone, just like support.
Once a support or resistance area or “zone” has been identified, those price levels can serve as potential entry or exit points. Since when the price reaches the previous support or resistance level, it will either bounce back away from the level or violate the price level and continue in its previous direction—until it reaches the next support or resistance level.
Some trades are timed based on the belief that support and resistance levels will not be broken. Whether the price is halted by or breaks through a support or resistance level, traders may “bet” on the price direction and quickly determine if they are correct.
If the price moves in the wrong direction (breaks through prior support or resistance levels), the position can be closed at a slight loss. However, if the price moves in the right direction (respects prior support or resistance levels), the move may be substantial.
Daily, weekly, and monthly charting periods all have support and resistance. Traders can also locate support and resistance in shorter time frames, such as one-minute and five-minute charts. However, the longer the period, the more significant the support or resistance.
Looking back at the chart for a significant pause in a price dip or rise to discover support or resistance. Then look to see whether a price halts and/or reverses when it approaches that level. As previously said, many experienced traders will pay attention to past support or resistance levels and place traders in anticipation of a similar reaction at these levels in the future.
Technical analysis is not an exact science; the price may fall below support levels or reverse before reaching the previous support level. The same applies to resistance: price may reverse before reaching or breaking over the prior resistance level. Flexibility is required in interpreting these chart patterns in each circumstance. This is why support and resistance levels are frequently referred to as zones.
These price levels are not magical in any way. Simply put, numerous market participants act on the same information and place trades at similar levels.
As shown in the chart below, resistance levels are considered a ceiling since they represent areas where a rally runs out of steam.
On the other hand, there is a lack of support. The price level on a chart when equilibrium is reached is referred to be supported. This signifies that demand has grown to match supply. As a result, the asset’s price has reached a price floor.
The horizontal line below the price denotes the price floor, as shown in the chart below. The blue arrows beneath the vertical line show that the price has touched this level four times in the past. This is the level at which demand kicks in, preventing further decreases. This is support.
The examples above demonstrate how a constant level prevents an asset’s price from moving higher or lower. This is one of the most prevalent types of support/resistance; however, because the price of financial assets generally trends upward or downward, it is not uncommon for these price barriers to change over time.
This is why the concepts of trending and trendlines are vital when learning about support and resistance.
When the market is trending upward, resistance levels arise when the price action slows and begins to move back toward the trendline. A reaction occurs when the price moves in the opposite direction of the prevailing trend.
Reactions can occur for various reasons, including profit taking or near-term uncertainty about a particular issue or sector. The resulting price action has a “plateau” effect, or a slight drop in currency price, resulting in a short-term top.
Many traders will pay close attention to the price of a security as it falls near the larger support of the trendline since, historically, this has been an area that has prevented the asset’s price from moving substantially lower.
When the market is trending downward, traders will look for a succession of dropping peaks and attempt to link these peaks with a trendline. When the price approaches the trendline, most traders will look for selling pressure and may consider entering a short position because this is an area that has previously pushed the price downward. The price must cross the trendlines at least three times to be valid.
With stronger trendlines, the price may contact the trendline numerous times over longer periods. In addition, the trendline in an uptrend is drawn below the price, and the trendline in a downtrend is drawn above the price.
The support/resistance of an identified level, whether detected with a trendline or by any other method, is deemed to be stronger the more times the price has historically been unable to move beyond it. Many technical traders will use their identified support and resistance levels to select strategic entry/exit points since these areas frequently represent the prices most influential to an asset’s direction.
Below is an example of a bearish trendline resistance on EURUSD daily chart.
Most traders are confident in the asset’s fundamental value at these levels; therefore, volume generally climbs more than usual, making it much more difficult for traders to continue moving the price higher or lower.
Most technical traders use the power of technical indicators such as moving averages to forecast future short-term momentum. People who find it challenging to create trendlines may frequently substitute moving averages for them.
A moving average, as seen in the chart below, is a continually changing line that smooths out past price data, making it simpler to identify support and resistance. When the trend is up, the asset’s price in the chart below finds support at the moving average, and when the trend is down, it acts as resistance.
Traders may use moving averages in a variety of ways, including anticipating moves to the upside when price lines cross above a significant moving average or exiting trades when the price falls below a moving average.
Whatever method is used, the moving average frequently generates “automatic” support and resistance levels. Most traders will experiment with different periods in their moving averages to discover the one that works best for their trading time frame.
Many indicators have been developed and are continually developed in technical analysis to identify barriers to future price action. Some indicators are plotted on price charts, while others are plotted above or below the price. These indicators might appear complicated at first, and learning to use them successfully takes practise and expertise.
However, regardless of how complicated an indicator appears, its application and interpretation are frequently the same as other indicators constructed using more straightforward methods such as calculating moving averages and drawing trendlines.
The Fibonacci retracement, for example, is a favourite tool among many short-term traders since it clearly identifies potential support/resistance levels. The reasoning behind how this indicator calculates the various levels of support and resistance is outside the scope of this article, but observe how the identified levels (dotted lines) in the chart below act as barriers to the price’s short-term direction.
Trading ranges can occur on occasion. These are areas where support and resistance levels are close together, and price bounces between them for a while. Experienced traders occasionally trade inside these trading ranges, also known as sideways trends.
They employ one strategy in which they place short trades when the price touches the upper trendline and long trades when the price reverses to touch the lower trendline. This strategy is risky, and it is far better to wait to see which direction the price will break out of the range and then place your trades in that direction.
When the price attempts to move back up, a previous support level will sometimes become a resistance level, and vice versa; a resistance level will become a support level when the price temporarily falls back.
Price charts enable traders and investors to visually identify areas of support and resistance, as well as provide hints about the significance of certain price levels.
Forex trading - What is the FX market? — 2023They specifically look at:
The more times the price tests a support or resistance level, the more significant the level becomes. When prices continue to bounce off a support or resistance level, more buyers and sellers take notice and make trading decisions based on these levels.
When steep advances or declines precede support and resistance zones, they are more likely to be significant. For example, a fast, steep advance or uptrend will be met with more competition and enthusiasm and may be halted by a more significant resistance level than a slow, steady advance.
The slow advance may not garner as much attention. This is an excellent example of how market psychology influences technical indicators.
The more buying and selling occur at a particular price level, the stronger the support or resistance level is likely to be since traders and investors remember these price levels and are apt to employ them again.
When there is a lot of activity on high volume, and the price drops, there will most likely be a lot of selling when the price returns to that level because people are considerably more comfortable closing out a trade at the breakeven point than at a loss.
Longer time frame charts, such as weekly or monthly charts, frequently have more significant support and resistance zones than shorter time frame charts, such as one-minute or five-minute charts.
Here is a four-step approach to help you identify and build the support and resistance lines.
If the objective is to identify a short-term S&R load, at least 3-6 months of data points are required. Load at least 12 – 18 months of data points if you wish to identify long-term S&R. When you load many data points, the chart appears compressed.
This also explains why the two charts above look squeezed.
Here is an example chart:
A price action zone is defined as “sticky points” on the chart when the price has demonstrated at least one of the following behaviours:
Here is a set of charts that identify the three points mentioned above in the same order:
The circular points in the chart below suggest the price is hesitant to move higher after a quick up move:
The circular points in the chart below reflect the price hesitant to move lower after a quick down move:
Many price action zones may be seen when looking at a 12-month chart. The secret is to identify at least three price action zones at the same price level.
For example, in this chart, two price action zones are identified, but they are not at the same price point.
Look at the following chart, I have encircled three price action zones that are around the same price points:
When selecting these price action zones, it is vital to ensure they are adequately spread in time. This means if the first price action zone is identified in the second week of May, it will be essential to identify the second price action zone at any point after the fourth week of May (well spaced in time). The greater the separation between two price action zones, the stronger the S&R identification.
A horizontal line connects the three price action zones. Based on where this line falls in relation to the current market price, it becomes either support or resistance.
From left to right:
In the preceding chart, all four price action zones are located near the same price point, 429. The horizontal line is well below the current market price of 442.5, indicating that 429 is an immediate support price for Cipla.
Please keep in mind that you incur the danger of approximation whenever you perform a visual exercise in Technical Analysis, such as detecting S&R. As a result, always leave space for mistakes. The price level is usually represented as a range rather than a single price point. It is a zone or area that acts as support or resistance.
Following the argument outlined above, I would be content to consider a price range of 426 to 432 as a support zone for Cipla. There is no set guideline for this range; I deducted and added 3 points to 429 to achieve my support price range!
Here is another chart for Ambuja Cements Limited that shows both S&R.
Ambuja’s current price is 204.1, with support at 201 (below the current market price) and resistance at 214. (above current market price). So, if one is overly short Ambuja at 204, the goal might be 201 based on support. This would most likely be a good intraday trade. Based on resistance, 214 might be a plausible goal expectation for a trader going long at 204.
At least three price action zones are identified at the price level at both the support and resistance levels, all of which are widely spaced in time.
Support and resistance levels are fundamental concepts technical analysts use and serve as the foundation for various technical analysis tools. The support and resistance are a support level, which can be thought of as the floor under the price, and a resistance level, which can be considered the roof above the price.
Prices fall and test the support level, which will either hold, and the price will reverse to the upside, or it will be violated, and the price will drop through the support and likely continue lower to the next support level.
Determining future levels of support can significantly boost the returns of a short-term trading strategy since it tells traders where price declines are likely to halt. Foreseeing a level of resistance, on the other hand, might be helpful since it alerts traders to be watchful as price approaches this area for a likely price reaction.
As previously said, numerous methods exist to pick from when attempting to identify support/resistance. Still, the interpretation stays the same: The trader is seeking signs that the price of a security will likely respond in a specific way when it approaches and touches a certain price level.
A trading strategy based on support and resistance allows you to profit from losing traders.
