Support and resistance - How to apply in trading
It is impossible to talk about technical analysis in financial markets without the topics of support and resistance coming up. It is the equivalent of trying to explain soccer without mentioning passing. Using support and resistance in trading is arguably the most widespread factor used in the strategies and approaches of traders. Which is why we will be explaining support and resistance and how to use it in your trading.
Simply put support and resistance are the price levels on a chart that act as barriers, meaning that the direction of the trend may be halted or even reversed at these levels. Support refers to the situation in which price falls to a particular price, where the power of buyers outweighs the power of sellers. Thus, a downward move in prices Is either halted or reversed. Resistance refers to the situation in which price rises to a particular price, where the power of sellers outweighs the power of buyers. Thus, an upward move in prices Is either halted or reversed.
The best way to remember this is to think of support as the floor that you stand on, without that support you would fall through the ground. The same goes for the prices of financial instruments, without any support (demand) prices would constantly be falling. For resistance, think of it as the ceiling of your home, you can jump up until that point but then you will hit your head and fall (**** ouch!). The prices of markets would constantly be going up without this resistance (supply)
You may notice that this is the same as supply and demand which is found generally in business and economics, this same concept drives prices in the financial markets and because of this traders need to understand this concept. Let’s look at a visual example to better understand support and resistance.
As you can see when prices reach the level of support, the majority of market participants expect prices to rise, so to be on the correct side they close out their sell positions and/ or open buy positions. At the resistance level, it is expected that prices will fall, therefore traders will usually close buy positions and/ or open sell positions.
Thus support and resistance levels become clear to the technical analyst when prices turn often at a certain level, so the support and resistance levels are drawn horizontally at the relevant price on the chart to be used for future speculation. It is important to note that prices will never turn at an exact price, support and resistance levels occur in a “price zone” therefore it is important to leave a small buffer to allow prices to react to the level.
Psychology plays an important role in the formation of support and resistance levels. This is because the prices that a market has reversed in the past are still in the mind of most traders and investors when price returns to these levels it is usually met with a lot of activity and money flowing into the opposite side of the current direction.
Now for the mind-blowing fact that most new traders miss out on, support and resistance is not perfect, there will be times (very often actually) that these levels will be breached due to continuous investment into the direction of the trend. But not all is lost, and these levels remain vitally important.
Here is why, try to stick with me, previous resistance becomes support once the level is broken and previous support becomes resistance when the price is broken. What this means is that these horizontal levels that we drew in earlier remain important, but now their effect will work in the opposite direction. Let’s look at a visual example of this.
This is the same example from earlier just further along, as you can see the resistance level that we drew was breached by buyers pushing the price through the level. The relevance of the level remained though when price returned to the level, the buyers came in again to push the price up.
To remember that support becomes resistance and resistance becomes support, keep the horizontal levels once they are breached on your technical analysis chart. But recall that support (demand) levels are relevant when prices are above the level and are moving down towards it, and resistance (supply) levels are relevant when prices are below the level and are moving up towards it.
How to use support and resistance in your trading?
One of the commandments of trading is buy support and sell resistance. This can be done in almost infinite ways due to the vastly different approaches to trading. However, all trading styles can be summarized into two groups: Reversal trading and trend trading.
In reversal trading support and resistance levels are used to enter buy or sell positions in the opposite direction to the current trend/ move. Because this is against the current market tide, to apply this approach successfully usually requires stronger levels. We will use our example from earlier to showcase this approach.
Using this approach in trend trading is also simple, using our explanation of levels changing from support into resistance and visa versa. All that I trader has to do is find a significant level that was breached by the trend, wait for price to return to this level and then enter a buy or sell position in the direction of this trend.
So say we are in an uptrend and price breaks a resistance level, that resistance level now becomes support and we wait to buy since we are trading with the trend. Once price returns to that now support level, it is an opportunity to buy and enter with the trend. This approach does not require significantly strong levels like reversal trading as the trader is going with the current market direction. Again we will look at our example from earlier to show where to buy and enter with the trend.
Determining the strength of support and resistance levels:
Since levels of support and resistance (or zones) are rather subjective there are many factors to take into consideration to determine the strength of levels:
- The number of times the market has tuned at a particular level, the more often it has turned the stronger the level.
- The strength of the move after the level has been tested. If the market responds rapidly to a level by moving quickly and far away from it, this means there is a stronger supply or demand at that level. The greater the response to the level the greater the strength of the level.
- The amount of volume traded at the level. This relates back to supply and demand, if there is more trading (volume) at a level this means there is greater supply or demand and thus the level is stronger. Less volume means less supply and demand, therefore the level is weaker.
In this article, we dived into what support and resistance levels are, showed how to apply it in trading and looked at what affects the strength of these levels.
It is important to keep in mind that these levels act more like “zones”, therefore they will hardly ever respond to an exact price.
Understanding trendlines takes application and practice, so open up your chart and draw a few lines to truly start taking the lessons in. Then the next step is implementing this in your trading.
Good luck and happy trading.