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 to take a trade. Among other things, it is technical analysis that gives the target and stop loss of a trade. In other words, while fundamental analysis represents the reason why the market is moving, the technical analysis gives the entry, exit and invalidation levels. Therefore, one without the other is not possible. Technical analysis is a vast subject, formed out of technical indicators (oscillators or trend indicators, volume indicators, etc.) or trading strategies, but also containing things like 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 side of the chart for predicting future price levels on the right 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 lower time frame (hourly or five-minute time frames) and one has an idea where price is hesitating, what levels are difficult to be broken, and that information can be used for predicting future prices.
Things to Know About Support and Resistance
These levels have many interpretations, and the reason why the price is hesitating around them is strongly related with supply and demand levels. There are always traders that want to buy on a dip or sell on a spike, as the reasons to enter 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 is moving it means there are imbalances in the supply and demand levels. Therefore, it means that the support or resistance levels have been cleared and the market gallops for the next ones.
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 is meeting resistance. Therefore, support turned into resistance, and everything that was valid from a support point of view, now it is true from a resistance point of view. The same is valid when resistance is broken, as that level will turn into a support one. The stronger the level, the stronger the new one will be. Traders are using 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 is doing that, stops are triggered and prices are moving strongly in that direction. Wise traders will wait to see if the former level is retested, and, in case it is, will use that opportunity for adding to the initial position. This is the best example of how a support can transform itself into resistance levels, and vice versa.
The classical way to interpret support and resistance levels is to simply look on the left side of a chart and chose levels where market used to hesitate. The next thing is to draw horizontal lines or areas to highlight those levels and drag them on the right side of the chart. Just like that, future horizontal support and resistance levels are found. The EURUSD example below gives the perfect example.
As it 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 trend line 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 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 not wondering that market is hesitating 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 EURUSD pair bounces from the next support level, it will meet a stiff resistance. The new resistance is given by the transformational characteristic of the previous support level. However, support and resistance areas are not only horizontal ones. This means that they are not forming only as a horizontal area, but also on a dynamic one.
A dynamic level refers to an area that is not horizontal. Typical dynamic levels are the retest of the b-d trend line of a triangle after it is broken, or the retest of the Schiff line in a Pitchfork, etc. We will treat both later in our project. For this moment, it is important to know dynamic levels are not horizontal. The example below shows the same EURUSD pair that broke lower and, after the wedge has been broken, it was retested! That is a dynamic resistance level, and it proved to be a great place to go short the pair.
Not only that the EURUSD retested the broken trend line, but it did that twice, offering a great opportunity to short 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 is happening 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 are used for such a long time in technical analysis that any new educational project must start with them. It doesn’t make them less useful. The bigger the time frame the support and resistance levels are being taken from, the more difficult for current price action to break them. Moreover, if multiple levels are forming on the same area, that is being called a confluence area and it is even more difficult for prices to break it.
Recommended Further Readings
- What is a Forex Broker and Types of Brokerage houses
– Explaining what a Forex broker is and does, how the business should be organized, and how many types of Forex brokers exist.
- Financial Products to Trade
– Different categories of financial products that a Forex Broker is offering for the retail clients, starting with the classical currency pairs, and continuing with commodities, CFD’s, indexes, etc.
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc.
- Forex Brokers Types – ECN or STP?
– What is ECN, STP, how d- brokers deal with client’s orders, advantages, and disadvantages of the tw- types.
- “An algorithm for testing the efficient market hypothesis.” Boboc, Ioana-Andreea, and Mihai-Cristian Dinică. PloS one 8, no. 10 (2013): e78177.
- “Lessons from the evolution of foreign exchange trading strategies.” Neely, Christopher J., and Paul A. Weller. Journal of Banking & Finance 37, no. 10 (2013): 3783-3798.