Support and resistance are fundamental concepts in the world of trading. They help traders gain an overall market background when analysing an asset’s price action, build expectations about price movements based on historical data, and make informed trading decisions. In this article, we discuss these concepts and provide some application strategies.
Understanding Support and Resistance
Support is a price level or area where a particular asset tends to find buying interest, experiencing a temporary halt or reversal in its downward price movement. It is often perceived by traders as a floor at which higher demand is very likely to emerge. Therefore, support levels can offer possible entry points for buying or exit points for a short position.
Resistance, on the other hand, is a price level or area where an asset faces selling pressure, causing it to pause or reverse its upward move. It is often considered by traders a price ceiling as it is where higher supply tends to emerge. Resistance levels help spot potential entry points for shorting an asset or exit points for a long trade.
A remarkable phenomenon is that once a support is breached, it tends to turn into resistance, and vice versa.
Supply and Demand Zones vs Support and Resistance Zones
Supply and demand zones differ from support and resistance lines in how they are identified and their fundamental concepts.
- Supply and demand zones are areas with a significant imbalance between buying and selling interest that may result in more significant market movements. In a demand zone, buyers overwhelm sellers and are willing to buy at a higher price, creating a floor; in a supply zone, sellers overpower buyers and are willing to sell at a lower price, establishing a ceiling. Supply and demand zones are more dynamic and may require a deeper understanding of order flow and liquidity.
- Support and resistance zones represent specific levels on the chart where historical price reversals have occurred. These levels can manifest as horizontal or sloping lines. They represent levels where significant buying (support) or selling (resistance) pressure has been evident. Support lines act as floors, preventing prices from declining further, while resistance lines serve as ceilings, curbing price increases. Support and resistance zones are more straightforward and rely on observable price levels.
How to Draw Support and Resistance Zones
To draw support and resistance zones, you need to:
- Identify Bounces: Begin by identifying historical price levels where the price has previously reversed.
- Seek Confluence: Pay attention to price levels where multiple bounces or reversals have occurred at roughly the same level. These areas of confluence are particularly significant.
- Draw a Horizontal Line: Once you've identified a strong price level, draw a horizontal line across that level on your price chart.
- Extend the Zone: Zones are not precise points but areas around the horizontal line. Extend the zone slightly above and below the line to account for potential price fluctuations.
Types of Supply and Demand Zones
In technical analysis, we distinguish between fixed static zones and dynamic zones. Also, there are strong zones of supply or demand as opposed to weak ones, which lack frequent testing or confirmation.
Dynamic vs Static
Static zones are fixed levels that remain constant and are derived from historical price data. These levels represent areas where market reversals or stalls have occurred in the past. In contrast, dynamic zones are flexible and responsive to current market conditions, often derived from indicators, e.g. moving averages. They adapt as new data becomes available and are particularly suited for traders who prefer to stay closely aligned with the evolving market dynamics. While static zones provide stability and historical context, dynamic zones offer responsiveness and adaptability to real-time price movements.
Strong vs Weak
Strong zones are pivotal levels which have repeatedly acted as barriers to price advances or declines, demonstrating their resilience over time as areas with concentrated buying or selling pressure. They are particularly significant when they coincide on multiple time frame charts or when they help identify a particular chart pattern. Additionally, major psychological levels, such as round numbers, often align with strong support and resistance zones. In contrast, weak zones have been tested infrequently or lack confirmation from substantial trading volumes.
Trading Strategies with Support and Resistance Zones
Traders employ several popular strategies based on the concept of price action within established supply and demand zones.
Bounce Trading Strategy
The bounce trading strategy relies on the price bouncing off support or resistance levels. Traders would look for confirmation signals, such as bullish/bearish candlesticks or oversold/overbought conditions. When these signals align, it may be a suitable entry point for a long or short trade with the expectation that the price will bounce off the support and rise or bounce off the resistance and fall.
A stop-loss order might be set just below the support level for long trades and just above the resistance level for short trades. However, as we are talking about zones, traders usually place a stop loss below the lower band and above the upper band of the range.
The take-profit level considers the asset’s volatility, aiming to capture a portion of the market move following the bounce.
Breakout Trading Strategy
The breakout trading strategy aims to catch a break of solid support and resistance levels. When the price approaches a strong resistance/support level and shows signs of potential upward/downward momentum, traders look for a breakout confirmation signal, such as a candle closing significantly above the resistance or below the support level. This event would trigger a long or short trade in the expectation that the market would continue to rise/fall.
Traders typically set a stop-loss order on the opposite side of the breakout level, which is considered a zone, not a single level, which additionally protects traders from an early exit. For a long trade, the stop loss is usually set just below the former resistance, which has now become support, and for a short trade, just above the former support (now resistance). Again, profit-taking levels consider the asset's volatility, and they might be set within the next longer-term support/resistance zone.
Chart Pattern Strategies
Support and resistance can be used to recognise chart patterns and benefit from trend continuations or reversals. Let’s consider an example with a wedge pattern. When observed during an uptrend, the ascending wedge is a bearish reversal pattern. A breakout below the lower boundary (support) completes the patterns and validates the bearish signal. Traders consider a breakout point as a zone as there is a risk of a pattern’s continuation.
A short position might be opened near the breakout level, while a stop-loss order might be placed just above the most recent high within the pattern. Determining the profit target typically involves measuring the pattern's width at its broadest point and deducting that value from the breakout level.
Multiple Time Frame Analysis Strategy
Multiple time frame analysis involves examining the same asset across different time frames with the purpose of identifying strong supply and demand levels which align across multiple time frames. Commonly, two time frames are analysed simultaneously, for example, the 1-hour and the 4-hour chart or the 15- and 30-minute chart. Support and resistance levels on both are identified, starting from the longer-term chart. When the price approaches a strong support/resistance level on a shorter time frame, traders may consider a long/short trade, whereby the bounce trading strategy discussed above can be applied to determine stop-loss and profit-taking levels.
Understanding support and resistance concepts empowers traders to create effective strategies based on key price levels. Using a range of trading strategies leverages strong demand and supply zones to determine potential entry and exit points and enable more effective risk management. Now, you may consider opening an FXOpen account and start testing support and resistance trading.
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