Technical Analysis – Support and Resistance Areas

Previous articles here on the Trading Academy project dealt with the importance of technical analysis, and why more and more people are looking at it as the decisive factor in taking a trade. Among other things, it is technical analysis that gives the target and stop loss of a trade. In other words, while the fundamental analysis represents the reason why the market is moving, the technical analysis gives the entry, exit and invalidation level, and hence one without the other is not possible. Technical analysis is a vast subject, comprising technical indicators (oscillators or trend indicators, volume indicators, etc.), or trading strategies, but also containing things such as support and resistance, patterns that have the power to predict price, and much more. In short, technical analysis refers to the ability to use the information on the left-hand side of the chart for predicting future price levels on the right-hand side. Among other things that are part of technical analysis, support and resistance levels or areas are central to any analysis. Simply looking at price action on a chart (the way prices move during a trading day) on a shorter timeframe (hourly or 5-minute timeframes) gives one an idea where the price is hesitating, and what levels are difficult to break; and that information can be used for predicting future prices.

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Things to Know About Support and Resistance

These levels have many interpretations, and the reason why the price hesitates around them is strongly related to supply and demand levels. There are always traders who want to buy on a dip or sell on a spike, as the reasons for entering a trade are different: technical, fundamental, long-term oriented, short-term oriented, etc. It is no wonder that the Forex market is a constant battle between bulls and bears, and when a currency pair moves it means there are imbalances in the supply and demand levels. It thus means that the support or resistance levels have been cleared, and the market gallops on towards the next ones.

The Transformational Characteristic

The first thing to keep in mind about support and resistance areas is that they have an important characteristic: they are transformational. This means that by the time a support level is broken, the market has a strong tendency to retest it. In doing that, it meets resistance. As a result, support turns into resistance, and everything that was valid from a support point of view is now true from a resistance point of view. The same is valid when resistance is broken, as that level will turn into a support level. The stronger the level, the stronger the new one will be. Traders use this characteristic to add to a position after the support and resistance levels are broken. For example, if a currency pair is taking a while to break a specific level, by the time it does that, stops are triggered and prices move strongly in that direction. Wise traders will wait to see whether the former level is retested, and, if it is, will use that opportunity to add to the initial position. This is the best example of how a support level can transform itself into a resistance level, and vice versa.

Horizontal Levels

The classical way to interpret support and resistance levels is to simply look on the left side of a chart and chose levels where the market used to hesitate. The next thing is to draw horizontal lines or areas to highlight those levels and drag them onto the right side of the chart. Just like that, future horizontal support and resistance levels are found. The EUR/USD example below gives the perfect example.
Support and Resistance Areas - 1
As can be seen, the pair formed a rising wedge, a bearish formation. As a rule of thumb, a rising wedge is expected to fall by the time the lower trendline is broken. That just happened, as the chart above illustrates. For having an idea where price might hesitate on its way down, the thing to do is to look at the former support levels that the market made during the wedge formation, and drag them on the right-hand side of the chart. This way, we just found out three possible support areas where the price should hesitate. As you can see, it is no wonder that the market hesitates around current levels, as they used to offer significant support during the wedge formation. On a clear break of a support level, there is no other until the next one is reached, and if the EUR/USD pair bounces from the next support level, it will meet stiff resistance. The new resistance is given by the transformational characteristic of the previous support level. However, support and resistance areas are not always horizontal. This means that they do not form exclusively  as horizontal areas, but occasionally as dynamic ones.

Dynamic Levels

A dynamic level refers to an area that is not horizontal. Typical dynamic levels are the retest of the b–d trendline of a triangle after it is broken, or the retest of the Schiff line in a Pitchfork, etc. We will cover both of these later in our project. For this moment, it is important to know that dynamic levels are not horizontal. The example below shows the same EUR/USD pair that broke lower level and, after the wedge had been broken, it was retested! That is a dynamic resistance level, and it proved to be a great place to go short on the pair.
Support and Resistance Areas - 2
Not only did the EUR/USD retest the broken trendline, but it did that twice, offering a great opportunity to go short on the pair. This is what a dynamic resistance level is, and if the wedge was a falling one, the level should have been a dynamic support one. Between the classical and dynamic support and resistance levels, the dynamic ones are more powerful. This happens because they incorporate a trending component, and this makes the rejection from such levels a violent one. There are plenty of examples that can be found to illustrate the important of support and resistance areas, and they have been used for such a long time in technical analysis that any new educational project must start with them. It doesn’t make them any less useful, though. The longer the timeframe the support and resistance levels are taken from, the more difficult it is for current price action to break them. Moreover, if multiple levels form on the same area, that is called a confluence area, and it is even more difficult for prices to break it.

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