Support and Resistance
Support and resistance (it's important!),
One of the most important concepts in technical analysis is probably the concept of support and resistance; in fact, it is possible to base an entire trading system on support and resistance alone. Support and resistance is often regarded as a complex and confusing by those just learning to trade, however, not only is the concept very simple it is also essential. If you don't understand support and resistance you should not be trading, period. What's more, support and resistance will never become obsolete because it's caused entirely by human nature; it has always existed in the markets and always will. Support and resistance exists in any market on any time frame, however as with all charts, the larger the trading time frame the less random the data and the stronger the time frame's trend. Most profitable chart patterns are caused by the effects of support and resistance.
What exactly is support and resistance?
Simply put, support is the level to which a price can fall before it finds a large enough number of buy orders to support the price and stop it falling any further. Resistance is the same thing in reverse - it is the level that a price can reach before a large number of sell orders will stop the price rising any further and push it back down. Support and resistance is easiest to see on bar or candlestick charts where you can see the day's (or period's) high and lows and not just the periods closing prices.
Identifying support and resistance levels,
Identifying exactly where a price will find support or meet resistance is not an exact science, however, if there are clear levels of support and/or resistance in the market it will show up clearly on the charts. Support will typically either be rising with the market or flat (staying at the same level) –
In this example, buying near the point where the rising trend line A (the support) was hit for the third time or where the flat support line B was hit for the third time would have most likely lead to a profitable trade. Note the
chart pattern at point B, a triple bottom, a classic bullish pattern.
Resistance will typically fall with the market or be flat and (like support) remain fixed at a constant level for some time –
Again, selling (shorting) the market when the price moves near the resistance line would have most likely have lead to a profitable trade.
What happens when support or resistance line fails to hold?
Trends never last forever so no support or resistance trend line (or level) will last forever; if it did the market would be forever heading in one direction, or stuck range bound between two points. The more obvious the trend line and the larger the time frame of the chart it appears on, the more likely the trend line is to hold and the more significant it's breaking is likely to be. When trend lines break the move in the opposite direction is often very violent; false breakouts usually occur on short time frames where the trend is moving in the opposite direction to the larger trend and large traders see the breaking of the smaller trend line in the opposite direction of the larger trend as an ideal price to enter the market. Once a significant area of support is broken it will often come to act as resistance when the price rallies. Like wise, resistance broken often becomes support when the market moves back to re-test the level.
Notice the resistance line at 1.2950; that area of resistance first forms in early May 2006 and lasts until late November 2006, it holds for over 6 months providing excellent shorting opportunities in early June and through out August and September. When the resistance at 1.2950 finally breaks down in late November 2006 there is a very violent move upwards, the market rallies over 400 pips in about a week before falling back to re-test the 1.2950 level in January 2007; notice how a level that previously acted as support is now acting as resistance. Throughout most of January and some of February 2007 there are a number of failed breakouts as the smart money buys into the drips and false breakouts against the main trend at around 1.2950. The EUR/USD then goes on to make new highs. The 'smart money', those large long term speculators looking at the bigger picture and following the longer term market trend would have no doubt made a lot of money simply by buying into the dips and false breakouts and waiting for the longer term trend to take the EUR/USD up.
Long term trends (i.e. trends lasting several years or more) are most likely to end at extremes. Bull markets typically end in at the heights of euphoria when almost everyone (bar the smart money) is convinced that the price will continue to rise forever and never go down - in such conditions there is nobody left to buy and push the price ever higher because they're already in; so the market stalls and then collapses as reality finally bites. Likewise, bear markets usually end quietly in the depths of despair once everyone that's going to give up has and there is nobody left to push the price lower - see my article about the COT and trader sentiment for more information.
Where is support and resistance most likely to be found?
Support and resistance (especially flat support/resistance lines) usually forms at round numbers, e.g. you're far more likely to see an area of support or resistance forming at say, 4500 than at say 4341. The example below is a daily candle stick chart of the British Pound's value vs. the value of the US Dollar. Notice how after a rally to around 1.9000 the market starts falling where it meets strong support at 1.8500. After four attempts or so the support at 1.8500 is finally broken and then later comes to act as resistance. Remember: Resistance broken often becomes support and support broken often comes to act as resistance. The market doesn't say below 1.8500 forever though and after many attempts does eventually break the resistance at 1.8500. After it does the 1.8500 level comes to act as support again in late October.
In Summary,
Understanding support and resistance is vital if you are going to succeed at trading, most profitable chart patterns that occur in the markets are the result of support and resistance. Support and resistance lines are strongest on large time frame charts - the bigger the trading time frame the stronger and more reliable the chart's trend. Support and resistance lines should by easy to spot, if you have to look to hard for them then you're probably seeing something that isn't there or a line which is particularly weak. Good traders try to see the market for what it is and leave their ego out of their trading, bad traders try and make the charts 'fit' their preconceived ideas. Support and resistance is one way to tell the direction the market is moving in without needing to wait for a signal from a lagging indicator, for example a break in a support or resistance line would most probably be a quicker way of signalling a change in trend than a technical indicator such as a moving average which might take much longer to detect the change. Support and resistance tells us approximately what levels prices are likely to rise or fall to and therefore tells us what prices are good levels to enter and exit trades at. Since the market often moves violently when levels of support or resistance are broken understanding support and resistance allows us to identify the areas where there is an increased risk.
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