Identifying Horizontal Support and Resistance from Previous Price History

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Identifying Horizontal Support and Resistance from Previous Price History

October 23, 2020

Support and resistance levels are essential to technical analysis as they reference areas on a chart where price has a tendency to consolidate and potentially reverse from its previous direction. You might also hear some traders refer to these as “demand zones” and “supply zones” for support and resistance, respectively. Conceptualizing it this way refers to the fact that at support, price is low (and hence drives up demand), while at resistance, price is high, which lowers demand and drives up supply. But for purposes of this post, we’ll reference these areas of price consolidation as support and resistance or simply S/R.

When I’m looking for S/R levels, I’m looking for an area that has been recently tested more than once and validated without being broken. Take a look at the first example:

We can see four bounces off of support in a short period of time on the USD/CAD 5-minute chart before retracing higher. Trades could have been taken at the green arrows I drew in and landed well ITM.

When looking at a market, obvious support and resistance levels should stand out pretty quickly to you after some time studying the charts. These levels are often observable as areas where price has been noticeably consolidating, often at completely different time periods on the chart. Also, these levels can denote the price extremes on the chart, or where the highest high and highest low of the price are located.

Here’s the same chart, but provides examples of what I do NOT consider to be reliable S/R levels:

Every dip and turn on a chart should not be considered as tradeable S/R. Where I’ve drawn my arrows are what might be termed “minor S/R” at least within the context of the price history that’s displayed.

Here is the most obvious example of S/R displayed on this CAD/JPY 15-minute chart:

The first wick gives indication of a price level rejection and a potential formation of a future level. Price came down and touched near that level again. Depending on the price action (which would ideally be viewed on a smaller timeframe), you could have taken a call option near that level. Further call options were later available at that price as it continued to hold.

Also note that the above chart is a 15-minute rather than the more commonly used 5-minute. Support and resistance lines are great to determine on the higher timeframes in that more noise is filtered out on the higher compressions and leaves you with more credible horizontal price levels. That said, on higher timeframes, more time is compressed into each bar so you will naturally have a lower number of S/R areas relative to the same period of time, which will likely present you with fewer trading opportunities. The tradeoff, of course, to using the higher timeframes to identify S/R is that the levels tend to be more robust and yield set-ups that have a better probability of landing in the money.

The most obvious level in the following USD/JPY example comes at the 79.793 price level:

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Price formed a double bottom before retracing back up. Price action may have been favorable to produce a call option at the second touch of 79.793 (first arrow) and certainly would have been a level of interest where the second green arrow is located for another call option.

In addition, this chart nicely reflects the importance of whole numbers as S/R in trading. Notice where the USD/JPY bounced off of – 80.001, or one-tenth of a pip above the clean, whole number of 80.00, which is commonly termed “psychological resistance” in this case. On major pairs, these are very important. For example, the round figures of 1.3000, 1.4000, and 1.5000 have produced significant price consolidation on the EUR/USD in its history. The GBP/USD has had several meanderings around 1.6000 in recent weeks. The 1.2000 EUR/CHF level is probably the most robust whole number S/R in all of forex at the moment, as it’s been publicly affirmed that the Euro will not be permitted to fall below a level that’s not at least 20% greater than the Swiss Franc (CHF).

Price levels are the main thing that I consider while trading. However, to be a successful trader they cannot be traded alone. They must be considered within the context of price action, meaning using the clues from the shape and patterns of price candles to make educated guesses regarding where price might go next. Taking a trade every time price simply hits a line on your chart will eventually result in disaster. You must do more to stack the odds in your favor than simply trading horizontal lines. You must consider current momentum, short-term (e.g., past hour, four hours) and long-term trend (e.g., past day, week) if applicable, news events, and even how far you are from potential S/R in the range that you’re looking to trade into. For instance, if you’re at a good support area, but price has been steadily declining over the past couple hours with weak retracements back up, and there’s minor resistance three pips above the current price, then you’re best off staying out of the trade entirely.

Most importantly, when looking for levels, choose those that have been tested more than once. If the price action has been choppy to the point where there doesn’t seem to be any favorable S/R to trade off of, don’t simply be content to choose mediocre levels as potential trading points instead or go overboard with how many you’re visually interpreting. That will cause you to take suboptimal set-ups and dampen your accuracy (i.e., overtrading). Confluence is key in trading set-ups. If the overall trend is up, you’re at a solid support area, you have a sizable range to trade into, and the retracement that brought you to support is showing exhaustion through price action (e.g., dojis, small candles), then it sounds as if you have a high-probability set-up and are looking at a great trade.

I definitely welcome any questions, so please don’t hesitate to leave a comment below!

UPDATE 24/10/2020 – In response to lots of questions I have made a follow up post on this topic here .

5 Ways On How To Identify Support And Resistance Levels That Matter In Forex Trading

If your support and resistance levels drawn on your charts look like this, then you need to see a doctor…

The 2 biggest problems with charts like the above are these: (1)It is messy and a messy chart just confuses the heck out of you (2)so if a messy chart confuses the heck out of you, how do you expect to trade well?

If you your charts look like that above, you need to start changing it to better show only the support and resistance levels that you really need. And I will show you can do that in this post.

The best thing you want on your charts is to have less clutter.

Less clutter means removing all the other “unnecessary things” that you don’t need and just have a clean refreshing chart with only the few things like a few indicators or support and resistance lines that you will need to make your trading decisions on.

Your Support and resistance charts should be like this:

  • note that I only have a few lines on this chart and removed everything else that did not matter.
  • you do not need to draw the blue boxes and the “R” and the “S”. These are just the most nearest support or resistance levels that I used to draw the support and resistance lines.

As you can see on the chart above, I’ve only highlight the support and resistance levels that matter in this situation.

Here’s the thing you need to understand about support and resistance levels: they occur in all timeframes.

  • Every timeframe has its own support and resistance levels.
  • The support and resistance levels found in the higher timeframes have much more significance than those found in smaller timeframes.

So in here, support and resistance levels that matter happen in larger timeframes and this post is about how to finding them.

5 Way To Finding Forex Support And Resistance Levels That Matter

Ok, now, I get to the meat of the article…how to draw support and resistance levels on your charts that matter.

#1: How Obvious Is It?

If you have a 5 or 6 year old child, try to show him a forex chart as ask him: How many mountain tops and valleys you can find on this chart?

That child is going to pick the most obvious peaks and troughs of price on your chart!

So the first thing you do when you scan your chart is to find levels that are so obvious to you and to thousands of other traders worldwide.

#2: Has Price Reacted To This Level On A Previous Occasion?

If price has reacted to a support and resistance levels on a previous occasion, then that gives you a really good clue that it is a support or resistance level of importance and you should expect the same sort of result when price hits that level again.

#3: Trading Timeframe

Well first, go back to the EURUSD chart above and notice that this chart is in the daily timeframe.

Support and resistance levels should be relevant to your trading timeframe based on the rules of you trading strategy, for example:

  • you may use the daily timeframe for your analysis of support and resistance levels but your trade entry can be based on the 4hr or 1 hour and your trade management can be based on the 1hr or the 4hour.
  • If you are trading the breakouts of support and resistance levels in the 5 minute timeframe then the support and resistance levels in the daily, weekly or monthly timeframes may not matter to you at all because it is irrelevant based on you trading system’s rules.

#4: Closeness of Price Action To That Of The Support And Resistance Level

If a support and resistance levels is too far away and price will not hit that level until like 6 months later, then it is absolutely pointless to draw such a line on your chart.

Price will not hit that level for a very very very long time and you don’t need that. So why put it there?

The only time that support or resistance levels needs to be drawn on your chart is when price action is very close to it and it is most likely going to hit it very soon, like in 2 weeks,days or even hours and you need to make your trading decision(s) based on that.

That’s when you draw it on your charts to make you aware of what is happening.

#5: Support And Resistance Levels Are Zones

Many forex traders think that support and resistance lines are just a fixed price level…that once you’ve identified it, wait for price to come to it and bounce off it or break it and take a trade based on those setups…

But the reality does not happen like that all the time.

If this was the case, drawing support and resistance levels would simply be a simple matter: find a price level where price bounced up or down from previously and draw a line and wait for price to come to it…and that’s it!

No, it doesn’t work like that all most times…

You see, there will be times when price will come exactly or be within a few pips or cross the support and resistance levels by a few pips and bounce.

Then there will be time when it will not hit the support or resistance level and bounce back even 10-20 pips (or even more)away from the support or resistance level.

Well, one reason why this happens is because of what is called support and resistance zones….

In a support or a resistance zone, expect price to move/bounce from anywhere within the zone.

This chart explains what a support and resistance zone means:

So how do you draw support and resistance level zones? Here’s what I do and I’m no saying this is the best way to do it:

  1. Identify the first resistance peak or the support trough and draw your first line.
  2. then as price moves along and then you have an outer extreme peak/trough form…that forms your outer line.

Note: the outer extreme line can be the first resistance peak as well as the support trough.

Support and Resistance Basics

The concepts of support and resistance are undoubtedly two of the most highly discussed attributes of technical analysis. Part of analyzing chart patterns, these terms are used by traders to refer to price levels on charts that tend to act as barriers, preventing the price of an asset from getting pushed in a certain direction. At first, the explanation and idea behind identifying these levels seem easy, but as you’ll find out, support and resistance can come in various forms, and the concept is more difficult to master than it first appears.

Trading With Support And Resistance

Key Takeaways

  • Technical analysts use support and resistance levels to identify price points on a chart where the probabilities favor a pause or reversal of a prevailing trend.
  • Support occurs where a downtrend is expected to pause due to a concentration of demand.
  • Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply.
  • Market psychology plays a major role as traders and investors remember the past and react to changing conditions to anticipate future market movement.
  • Support and resistance areas can be identified on charts using trendlines and moving averages.

Support and Resistance Defined

Support is a price level where a downtrend can be expected to pause due to a concentration of demand or buying interest. As the price of assets or securities drops, demand for the shares increases, thus forming the support line.   Meanwhile, resistance zones arise due to selling interest when prices have increased.

Once an area or “zone” of support or resistance has been identified, those price levels can serve as potential entry or exit points because, as a price reaches a point of support or resistance, it will do one of two things—bounce back away from the support or resistance level, or violate the price level and continue in its direction—until it hits the next support or resistance level.

The timing of some trades is based on the belief that support and resistance zones will not be broken. Whether the price is halted by the support or resistance level, or it breaks through, traders can “bet” on the direction and can quickly determine if they are correct. If the price moves in the wrong direction, the position can be closed at a small loss. If the price moves in the right direction, however, the move may be substantial.

The Basics

Most experienced traders can share stories about how certain price levels tend to prevent traders from pushing the price of an underlying asset in a certain direction. For example, assume that Jim was holding a position in stock between March and November and that he was expecting the value of the shares to increase.

Let’s imagine that Jim notices that the price fails to get above $39 several times over several months, even though it has gotten very close to moving above that level. In this case, traders would call the price level near $39 a level of resistance. As you can see from the chart below, resistance levels are also regarded as a ceiling because these price levels represent areas where a rally runs out of gas.

Support levels are on the other side of the coin. Support refers to prices on a chart that tend to act as a floor by preventing the price of an asset from being pushed downward. As you can see from the chart below, the ability to identify a level of support can also coincide with a buying opportunity because this is generally the area where market participants see value and start to push prices higher again.

Trendlines

The examples above show a constant level prevents an asset’s price from moving higher or lower. This static barrier is one of the most popular forms of support/resistance, but the price of financial assets generally trends upward or downward, so it is not uncommon to see these price barriers change over time. This is why the concepts of trending and trendlines are important when learning about support and resistance.

When the market is trending to the upside, resistance levels are formed as the price action slows and starts to move back toward the trendline. This occurs as a result of profit-taking or near-term uncertainty for a particular issue or sector. The resulting price action undergoes a “plateau” effect, or a slight drop-off in stock price, creating a short-term top.

Many traders will pay close attention to the price of a security as it falls toward the broader support of the trendline because, historically, this has been an area that has prevented the price of the asset from moving substantially lower. For example, as you can see from the Newmont Mining Corp (NEM) chart below, a trendline can provide support for an asset for several years. In this case, notice how the trendline propped up the price of Newmont’s shares for an extended period of time.

On the other hand, when the market is trending to the downside, traders will watch for a series of declining peaks and will attempt to connect these peaks together with a trendline. When the price approaches the trendline, most traders will watch for the asset to encounter selling pressure and may consider entering a short position because this is an area that has pushed the price downward in the past.

The support/resistance of an identified level, whether discovered with a trendline or through any other method, is deemed to be stronger the more times that the price has historically been unable to move beyond it. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit points because these areas often represent the prices that are the most influential to an asset’s direction. Most traders are confident at these levels in the underlying value of the asset, so the volume generally increases more than usual, making it much more difficult for traders to continue driving the price higher or lower.

Unlike the rational economic actors portrayed by financial models, real human traders and investors are emotional, make cognitive errors, and fall back on heuristics or shortcuts. If people were rational, support and resistance levels wouldn’t work in practice!

Round Numbers

Another common characteristic of support/resistance is that an asset’s price may have a difficult time moving beyond a round number, such as $50 or $100 per share. Most inexperienced traders tend to buy or sell assets when the price is at a whole number because they are more likely to feel that a stock is fairly valued at such levels. Most target prices or stop orders set by either retail investors or large investment banks are placed at round price levels rather than at prices such as $50.06. Because so many orders are placed at the same level, these round numbers tend to act as strong price barriers. If all the clients of an investment bank put in sell orders at a suggested target of, for example, $55, it would take an extreme number of purchases to absorb these sales and, therefore, a level of resistance would be created.

Moving Averages

Most technical traders incorporate the power of various technical indicators, such as moving averages, to aid in predicting future short-term momentum, but these traders never fully realize the ability these tools have for identifying levels of support and resistance. As you can see from the chart below, a moving average is a constantly changing line that smooths out past price data while also allowing the trader to identify support and resistance. Notice how the price of the asset finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down.

Traders can use moving averages in a variety of ways, such as to anticipate moves to the upside when price lines cross above a key moving average, or to exit trades when the price drops below a moving average. Regardless of how the moving average is used, it often creates “automatic” support and resistance levels. Most traders will experiment with different time periods in their moving averages so that they can find the one that works best for this specific task.

Other Indicators

In technical analysis, many indicators have been developed to identify barriers to future price action. These indicators seem complicated at first, and it often takes practice and experience to use them effectively. Regardless of an indicator’s complexity, however, the interpretation of the identified barrier should be consistent to those achieved through simpler methods.

The “golden ratio” used in the Fibonacci sequence, and also observed repeatedly in nature and social structure.

For example, the Fibonacci retracement tool is a favorite among many short-term traders because it clearly identifies levels of potential support/resistance. The reasoning behind how this indicator calculates the various levels of support and resistance is beyond the scope of this article, but notice in Figure 5 how the identified levels (dotted lines) are barriers to the short-term direction of the price.

Measuring the Significance of Zones

Remember how we used the terms “floor” for support and “ceiling” for resistance? Continuing the house analogy, the security can be viewed as a rubber ball that bounces in a room will hit the floor (support) and then rebound off the ceiling (resistance). A ball that continues to bounce between the floor and the ceiling is similar to a trading instrument that is experiencing price consolidation between support and resistance zones.

Now imagine that the ball, in mid-flight, changes to a bowling ball. This extra force, if applied on the way up, will push the ball through the resistance level; on the way down, it will push the ball through the support level. Either way, extra force, or enthusiasm from either the bulls or bears, is needed to break through the support or resistance.

A previous support level will sometimes become a resistance level when the price attempts to move back up, and conversely, a resistance level will become a support level as the price temporarily falls back.

Price charts allow traders and investors to visually identify areas of support and resistance, and they give clues regarding the significance of these price levels. More specifically, they look at:

Number of Touches

The more times the price tests a support or resistance area, the more significant the level becomes. When prices keep bouncing off a support or resistance level, more buyers and sellers notice and will base trading decisions on these levels.

Preceding Price Move

Support and resistance zones are likely to be more significant when they are preceded by steep advances or declines. For example, a fast, steep advance or uptrend will be met with more competition and enthusiasm and may be halted by a more significant resistance level than a slow, steady advance. A slow advance may not attract as much attention. This is a good example of how market psychology drives technical indicators.

Volume at Certain Price Levels

The more buying and selling that has occurred at a particular price level, the stronger the support or resistance level is likely to be. This is because traders and investors remember these price levels and are apt to use them again. When strong activity occurs on high volume and the price drops, a lot of selling will likely occur when price returns to that level, since people are far more comfortable closing out a trade at the breakeven point rather than at a loss.

Support and resistance zones become more significant if the levels have been tested regularly over an extended period of time.

The Bottom Line

Support and resistance levels are one of the key concepts used by technical analysts and form the basis of a wide variety of technical analysis tools. The basics of support and resistance consist of a support level, which can be thought of as the floor under trading prices, and a resistance level, which can be thought of as the ceiling. Prices fall and test the support level, which will either “hold,” and the price will bounce back up, or the support level will be violated, and the price will drop through the support and likely continue lower to the next support level.

While spotting support and resistance levels on a chart is relatively straightforward, some investors dismiss them entirely because the levels are based on past price moves, offering no real information about what will happen in the future.

Determining future levels of support can drastically improve the returns of a short-term investing strategy because it gives traders an accurate picture of what price levels should prop up the price of a given security in the event of a correction. Conversely, foreseeing a level of resistance can be advantageous because this is a price level that could potentially harm a long position, signifying an area where investors have a high willingness to sell the security. As mentioned above, there are several different methods to choose when looking to identify support/resistance, but regardless of the method, the interpretation remains the same—it prevents the price of an underlying asset from moving in a certain direction.

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