- August 14, 2020
- Posted by: NetPicks
- Category: Trading Article
What are support and resistance levels?
“Support is a level or area on the chart under the market where buying interest is sufficiently strong to overcome selling pressure. As a result, a decline is halted and prices turn back again. . . . Resistance is the opposite of support” (Murphy 1986).
The way that many market participants view levels is as support and resistance turning points where they can find entry and exit points and define their level of risk.
- You identify a price, price zone, or round number that has historically supported price
- You believe the market will move higher from this area
- You go long at this zone and place your stop below the zone when price moves to it
From a trading risk standpoint it makes sense as you know when you are wrong and how much you can lose (disregarding any slippage).
The truth is….It’s not the best way to trade support and resistance and here’s why.
Every Moment Is Unique In The Market
Trading based on support or resistance levels alone is like trading with blinders on.
It’s easy to identify specific prices that have historically demonstrated their value as support or resistance and the temptation which follows is to take a trade at the price when the level is revisited.
This could be a disaster.
- Are the same traders who turned the market before going to be there again?
- Are the same market conditions present?
- Is the context the same?
When I’m talking about a level of support or resistance, I’m not talking about mathematically generated levels.
I’m not talking about pivot points or Fibonacci retracements.
I’m also not talking about trend lines as a means of determining support and resistance. Even though trend lines are popular, there are many trading examples where a down sloping trend line will break to the upside and run straight into a horizontal resistance zone.
What I am talking about are price levels where actual trading activity has previously entered the market and prevented prices from rising/falling further or started a larger move.
- These levels can be weak just as they can be strong.
- Weak levels can hold just as strong levels can fail.
So what any level is in reality is a reference to previous trading activity.
Sometimes the market will:
- turn from them
- break them
- push through them by just enough to stop you out before it reverses – false breakout
Whatever the market does, by observing the action at or around a level you are able to find context with which you may be able to identify excellent trading opportunities.
Problems With Drawing Trend Lines For Support and Resistance
I know some chartists will challenge me on the use of trend lines but you will find that many long time chart technicians have forsaken the trend line not only for support and resistance but also the chart patterns that use them.
Let’s explore an example and look at trendlines and the main issue with using them for price patterns.
After two peaks, I am able to draw a trend line to connect the points. Traders that play breakouts of trend lines will monitor price as it breaks the line.
In this example, each break of the trend line rallied but stopped dead in the tracks right near the horizontal resistance line. If you were a long trader this would have caused you grief as the market continued to pullback against you.
It wasn’t until price consolidated under the horizontal resistance line (a bullish sign) that we eventually get a strong break of resistance for a long trade.
That’s not to say you can’t use trend lines in this manner. Just be on the watch for horizontal support and resistance levels that may cause a speed bump or detour.
How To Find Support and Resistance Levels
There will be a few methods to draw your support and resistance zones and you could question each of them. How do you know your lines are any better than random?
- Turn off your candlesticks or bars on your charts
- Start drawing random horizontal lines
- Turn your candlesticks back on
What are you seeing when you look at the chart?
- Do you see where price has bounced from your random lines?
- Do you see where price bounced a few times?
- Do you see where support and resistance switched roles?
If random lines seemingly reject price, how will you make sure your lines are valid?
One way to determine your support and resistance levels is to use basic market trend structure.
- A market in an uptrend will produce higher highs and higher lows.
- A market in a downtrend will produce lower highs and lower lows
- A market in a range will produce both
“Usually, a support level is identified beforehand by a previous reaction low,” and “a resistance level is identified by a previous peak” (Murphy 1986)
Our rules for defining support and resistance levels are:
- Some type of trending pattern and this example is an uptrend
- Once a swing high is put in (HH), price rejects from price point (resistance) and then exceeds resistance, we will mark that area as former resistance and POTENTIAL support.
- At point marked “A”, you can see we have a higher low and then lower high. This negates the uptrend pattern and you can see price has put in a triangle pattern.
- At point marked “B” price holds inside of highs and lows and it’s labelled a trading range
- Price breaks lows of range and rejects off previous resistance which has now produced a support level
You will want to note that price will not always return to a former “reaction low” as mentioned by Murphy in the quote above.
There will be times where price will return to the former area of resistance and that zone will act as support as buyers enter the market.
This is a simple and objective price action method to identify your support and resistance zones using pure market structure. You can also use prior day high and lows for your financial instrument but with markets heading to 24 hour trading (Forex is already there), you may want to define the time you use for open and close such as 5 P.M. New York.
Don’t get too caught up in exact price points with your lines. Remember these are zones. Price is rarely perfect.
How Markets React To Support and Resistance Levels Matters
In order to better understand the context extracted from the market’s reaction to a level such as price rejection or acceptance, it’s useful to discuss an example.
This is an older chart of the ES primary session where prices were dropping in spite of the fact that in early trading there had been an attempt at moving higher.
The first context was it wasn’t able to hold above the prior session’s high and close.
As prices approached the prior day’s low at 1620.75, selling was decent and given that the earlier attempt to go up had failed, there was reason to suggest that 20.75 wouldn’t hold for too long if at all.
However, at 1621.50 there was a quick turnaround in the market.
In the face of all that selling, the ES rejected Monday’s low before even getting there. It then tested lower a couple of times without getting close to making new lows and it held.
At this point, the chances of a move higher into close were elevated. In the end, the ES pushed 57 ticks from its low to its last high before the RTH close.
Using this context to support you, there was money to be made given the context. Realistically though, there will be times when it’s profitable to take trades at specific levels.
As I’ve already pointed out, the fact that you are identifying market structure to define the amount of risk you are willing to take is certainly one compelling reason to use levels as trade entry points.
Sometimes levels work so well that it’s not hard to see why traders can be convinced at their unconditional validity.
Support And Resistance Zones Must Eventually Break
However, if all levels were going to hold all of the time the markets would never move.
So the question is that if you are going to enter at levels of support or resistance, which do you choose and when are they valid?
One determining factor you may use to determine a “strong level” is the amount of time price rejected at each data point.
That is not a good trading method.
Hits on a support or resistance level actually weakens the level. Each time price revisits a level, stop loss orders accumulate underneath the zone as you can see by the increasing line thickness.
These make prime areas for an influx of order flow as these orders are triggered. Depending on the amount of stop loss orders beneath the support line and the amount of breakout traders standing by, price can move fast and hard away from the level.
You can note by the green circles that once you start to see price not rallying far from the level or price begins to base at the zone, extra caution must be taken if you are considering a trading opportunity.
In order to trade at a level it’s important to see context, confluence (ideally other reference points aligning) and the right sort of trading activity on approach, all working together.
Moving Averages To Define Dynamic Levels
We’ve all heard about moving averages such as the 50 period average, the 100, 200, and even 20 periods. Many traders believe that these lines act as “dynamic” support and resistance levels.
Dynamic as in they change with price.
The truth is the calculation of the moving average needs, as an example, 50 data points which are generally the closing prices.
As price begins to lose momentum, the range between closing prices gets smaller. The moving average will then draw closer to price giving the illusion that it is supporting price.
It is just the moving average calculation taking place as the closing prices between each day are not as wide as they were previously.
How To Trade Support and Resistance Levels
Since we understand that all support and resistance levels can break, how do we take a trade from the level?
Remember, support and resistance zones are market reference points that allow you to have some structure to your trading decisions at locations where there is potential for price movement.
You don’t have to trade support and resistance zones to get the benefit of them. Seeing how price reacts to this points can be just as valuable depending on your trading strategy.
Once you’ve determined support and resistance zones that you will keep an eye on, the next stage is to watch for signs that the level will either hold or fail.
- Strong drop in price and a long tail candlestick (pin bar, kangaroo tail) rejects at the previous resistance now acting as support level. We’d call this minor support since price has not visited prior to this event.
- This is the first peak but highlights a bearish candle that takes out the real body of the bull candlestick. This is a move you can trade
- Another reject of support now called major support since it has rejected price more than once.
- Engulfed candlestick at major resistance
- Price consolidates at support with an obvious resistance line.
- Price then consolidates at top of range which indicates bullish intent. You can position inside this smaller range.
- Lack of bullish momentum at resistance as shown by smaller candlesticks.
- Range with obvious support and resistance levels. Strong break of support and price pulled back to test.After price breaks all previous support, a pullback trade sets up another shot to the downside.
This one chart example has shown many candlestick formations that you can look for at these zones.
False Breakouts Of Zones Are Common
Many breakout traders get nailed when price tests a level, appears to want to break and then simply snaps back up.
These are called false breakout or failure tests.
In this chart, price has ran into resistance and pulled back. You know that traders have been going short or exiting longs because price had not broken through.
Remember what we talked about earlier? Protective stops are accumulating just beyond resistance and the traders on the sidelines are waiting for price to break resistance so they can go long.
At the right of the chart, price runs from the low end of consolidation and after a small battle as indicated by long lower shadows, price pops the resistance area at the black arrow.
Price had a decent run but eventually slammed back almost closing below the open. Is this the sign of a successful breakout?
By the looks of the massive bear candlestick that wiped out 3 days of gains, those that went long are getting hammered.
After a brief consolidation, hopeful bulls see the end is near and the second huge momentum candlestick indicates the probability of other shorts entering the market and bulls finally exiting their position.
False breakouts of support and resistance, even if you don’t trade them, tell a story that the zone is still of interest and acting as a barrier to price. That may aid you in taking a trade short in virtually any trading strategy.
Shorting At A Support Zone Example
The general rule is not to short into support or buy into resistance.
That’s a rule that may be ignored and price action will dictate behaviour (this happens to be my favorite setup).
- Strong momentum move to the downside and price rallies giving us a support line and resistance line.
- Price drops back to support at the first green circle but buyers hold the move
- Second green circle shows sellers stepping in strong but the slight drifting upwards after shows bulls holding on
- Price drops and begins to consolidate
- The last green circle shows price dipping below the support level of the range and popping back inside.
- Price is unable to gain traction to the upside
This is a prime location to enter the trade!
Price action has shown you that at this critical area, the bears are the ones holding the cards.
Your stop would not be placed just above the zone (remember stop runs?) but you may use an ATR stop as an example.
You are positioned before the break which means:
- Before stops are triggered
- Before breakout traders step in
It is not uncommon to ride the wave of momentum and be up a considerable amount long before others get wind of the trading opportunity.
Identify Support On Higher Time Frames
It is a good practice for traders to examine higher time frames for levels close to current price. Identify support or resistance levels on a time frame 3-5 times higher than your trading time frame, can help identify roadblocks to price.
As an example, if you get a strong buy setup on a daily chart, take a look at the weekly or monthly chart to see if overhead resistance is close by.
Higher time frames will have less levels than a smaller time frame which means they will be obvious to other market participants.
Going long into a resistance zone could make for a painful trade as price is rejected at highs. This may be a better place to look at a short trade.
Useful Technical Analysis Tool
The assumptions that either levels ‘work’ all the time or they are,as the trader at the beginning had decided, non-existent, are both flawed.
Once you understand what they really are, you’ll see just how useful they can be whether you day trade, swing trade and regardless of the time frame chart you are using.
Support and resistance zones will either hold or break. That’s it. Find your own method of determining which one has a higher probability of occurring and take action.
Keep in mind that if a level breaks, you don’t expect price to come roaring back inside of the level. You expect pullbacks to the breakout zone to be weak. This is where understanding what a failure looks like at the zone.
Trading support and resistance is a viable part of a trading strategy that includes risk management and trading psychology. Practice locating and drawing your levels and monitor the behavior of price when the line breaks and when it holds.
Hands on is the best teacher so crack open your charts and staring perfecting your use of support and resistance trading.