Support and resistance levels constitute one of the basic pillars of technical analysis. Nevertheless, often traders tend to overlook these indicators, considered to be too simple to provide true results: nothing more wrong.
Support and resistance are more than simple lines in a price chart: they constitute zones of congestion in which price, on average, tends to re-bounce. Following the traditional definition:
- Support level – is an area on a chart in which potential buying pressure could push price higher (upward re-bounce);
- Resistance level – is an area on a chart in which potential selling pressure could push price lower (downward re-bounce);
Price tends to respect those structures and during the phases of consolidation it tends to move inside ranges formed by these areas of buying or selling pressures (see the example above).
Support and Resistance: Magnets for Price Action
So, now that we know what support and resistance are, a question should come in your mind: why are they so important for a technical trader? The answer is simple: because they act as magnet for price action.
During its walk, price tends to retest these areas on the chart multiple times. Look at example below about GBP/USD on a daily chart. Price test the green resistance 2 times, but is not able to break the structure; eventually, it acquires more strength, and at the third tentative it manage to break upward.
Nevertheless, this is not enough: price bounce-back and re-test the broken structure that now constitute a zone of support. To notice this passage is fundamental, since allow us to understand that support and resistance indicators invert their role. A broken resistance becomes a support, while a broken support turns into a resistance.
How to Draw Support and Resistance Lines
We draw support and resistance lines between at least 2 points of inflection in the market. This seems to be too simplistic, but is actually how it works. In TradingView, a free online resource for financial markets visualisation, simply select “trend lines tool” on the left bar of instrument, and then click on “Horizontal line”.
#Practicaltip: Even though support and resistance are often represented using lines in the charts, we must remember that these are zones, and not precise lines, in which price tends to re-bounce. If we do not remember this key factor, we might miss some trading opportunities, since we may consider a true price re-test as a failure one, if this is not perfectly clear. For that reason, I personally prefer to draw these areas using the “Rectangle” instrument on Tradingview, in a similar way as I did for the previous example.
How to Find Support and Resistance Levels
The simple rule provided above for draw support and resistance lines (connect at least 2 point of inflection in the market), can lead us to encounter some difficulties.
Market action is often erratic and price peak and trough are usual. The result is that price tends to form a large number of support and resistance structures. If we consider all of them, our screen will appear like this one:
Too much confusion, isn’t it? In my opinion, a chart like this is completely useless and in some cases even harmful.
That’s why we have to focus only on what really matter: “less is more”. But how can we spot the most significant levels of price in the market? Well, as usual, as technical traders we investigate past price action to make weighted guess about future.
Support and Resistance: Elements of Reliability
The fundamental factor who influence support and resistance reliability (and so importance in the market), is the time dimension. The more an area in the chart has been valid in the years, the more this particular structure is significant.
An additional clue about support and resistance reliability is the number and clarity of price re-test. The more a level has been touched by price, the more it is significative for the market. Probabilities that such structure will hold in the future, supporting or halting the action of price, are greater for levels that have been touched multiple times compared to the ones for levels not tested enough times.
An additional clue of resistance and support reliability is the number and clarity of re-test: the more a level is touched by price, the more a level is significative for the market. Probabilities that a structure will hold in the future, supporting or halting the action of price, are greater for levels that have been touched multiple times compared to the ones for levels not tested enough times.
There are additional elements that we should consider for the identification of the most important zones of support and resistance. Indeed, we can identify important areas of congestion nearby:
- Clearly identifiable previous highs or lows;
- Rounded numbers, like for example in forex market 1.00 – 1.10 – 1.20 and so on;
- Hidden support and resistance levels based on Fibonacci extension or retracement, or Gann levels;
- Market gaps;
- Trend lines and moving averages;
- Retracement on previous impulses during a trend (see first chart).
Support and Resistance: Timeframe influence
Timeframe play a fundamental role when assessing the reliability of a market structure. As a general rule, the higher the timeframe, the higher the importance of the support and resistance identified.
The reason behind this is quite simple and logic. Let’s consider the above example about EUR/USD. Each candle represent a week of exchanges in the market, and the support created in October 2005 is still valid and evident in the market nowadays. This means that almost all the market participants are aware about the existence of this level, and for sure they will make buying or selling decisions nearby this area.
Things completely change if we consider for example a 5 minute chart: in this case, market structures are less evident in the market compared to a weekly one and price reaction nearby these areas will be less disruptive.
Identify a Valid Structure Breakout
The identification of a structure breakout could be quite challenging especially for a novice trader. Although on a later basis a breakout of a support or resistance could be quite easily identifiable, on a prior basis we might encounter some difficulties in distinguish a true invalidation from a false one.
Though, support and resistance trading is highly dependent on the identification of valid or invalid breakouts. For that reason we must establish a method to filter-out false violation in order to avoid losses (as much as possible, of course).
The identification of a valid structure violation rely on the filter used, a choice that is highly subjective. There are a lot of different methods, but personally I look at price bar’s close. We have a:
- Break above – whenever next candle after the breakout close above previous close;
- Break below – whenever next candle after the breakout close below previous close.
That’s all for today! I hope you enjoyed learning about support and resistance and I wish you are now aware about the fundamental importance of these indicators for technical traders. I advise you to put in practice what you’ve learned today: don’t stick only to theory, but start to move inside price charts. Your confidence will increase. Visit our blog and continue your learning process!