The ChoosaBroker Trading Academy
11.1. Identifying Support and Resistance on Price Chart
An underlying asset’s price is a derivative of the interaction between the forces of demand and supply. Demand represents how much of the asset is desired by buyers. The amount of quantity demanded is dependent on the price market participants are willing to pay. Supply indicates how much of the underlying asset sellers can offer. The quantity supplied is also a variable of the price people are willing to accept.
At its most basic level, the price of an underlying asset rises when demand outweighs supply. On the other hand, if sellers outnumber buyers, prices decline. This is at the crux of technical analysis of financial assets. Once you are able to grasp this elementary yet very important concept, your trading view will get much more logical.
Demand – Supply Mismatch
The demand and supply imbalances in an underlying market can be visually seen on a price chart. Let us assume that an asset’s price is falling. Some bullish traders are more than likely to place pending “buy” orders at some distance below the current price. They will be hoping that price will not go much lower. If a substantial number of market participants do the same, there will be a big accumulation of pending “buy” orders around this specific price zone. As a result, when price reaches this area, a sharp rise is the most likely outcome.
The same principle holds true in the opposite direction. When a large chunk of sell orders get accumulated at some distance above price, a reversal can be expected once prices reaches that area. Traders should be conscious of these two important price levels within a chart – “Support” (Demand Zone) and “Resistance” (Supply Zone).
What is Support?
A “Support” can be simply defined as a price level or an area beneath the current market action where strong buying interest exists. If we look at the below given chart, we can see there is considerable buying interest at the green horizontal zone, most likely due to a large number of pending “buy” orders resting around that level. As a result, when price reaches the Support zone, the orders get executed, leading to a sharp price rebound away from the demand zone.
What is Resistance?
A “Resistance” is an area located above the current price action, where a big volume of “sell” orders has been placed by traders, who are anticipating that price is unlikely to move much higher. When market action reaches this zone, the orders start getting executed, and price reverses to the downside.
Drawing Support and Resistance Zones on Chart
Finding Support and Resistance area on a price chart is not as complicated as it sounds. All that traders’ need to do is focus on important price turning points on any time frame. Typically, a turning point from where price moves swiftly lower can be considered a Resistance zone. Conversely, a turning point from where price bounces higher can be defined as a Support zone.
Whenever you find such key price turning points, simply extend a horizontal line to the right. Price has memory and will often reverse from levels it has respected in the past.
How to Structure a Trade after Identifying Support and Resistance Levels?
Support and resistance zones are horizontal price levels that typically connect price bar lows to other price bar lows, and highs to highs, respectively. Since more often than not, price tends to respect these Support-Resistance levels, traders can expect a rally off a Support area, and a sell-off from a Resistance zone.
Let us learn a simple trading strategy to profit from these expected price reversals.
01. Mark your areas of Support or Resistance on a chart.
02. Wait for a directional move in to Support-Resistance
03. Wait for price rejection at Support-Resistance
04. Enter on the next candle bar with protective stop loss placed just beyond the last price peak/trough
How to Trade if Support-Resistance is Broken?
During strongly trending markets, it is commonplace to see price not respect previous Support-Resistance zones. In case of an uptrend, bulls (buyers) are in control of the market, and are likely to absorb the selling pressure, resulting in price breaking out above a Resistance zone. Traders can enter long on a convincing close above the Resistance area, with a stop loss placed just below the last major price trough. However, volume needs to be monitored closely to confirm that the breakout isn’t false. Most successful upside breakouts past a Resistance are accompanied by a substantial increase in volume.
During a down trend the reverse is true. Bears (sellers) are in control of the market, and are likely to absorb the buying pressure, resulting in price piercing through a Support zone. Traders can enter short positions on a convincing close below the Support area, with a stop loss placed above the last major price peak. Since prices can fall on their own weight, the break-down below a Support need not be accompanied by a surge in volume.
Setting Stop Loss Based on Support-Resistance Levels
A sensible approach to determining where to place your stop loss levels is to base it on what the price charts are saying. Often times, price struggles to push beyond certain levels. When these Support or Resistance levels get retested, they potentially could prevent the market from breaching through them once again.
Setting your stop losses beyond these areas of Support and Resistance makes sense. In case price manages to trade beyond these levels, it is reasonable to assume that more traders will enter the market to play the breakout, further pushing your position against you. Given the above scenario, it is rational to place an initial stop loss just below the last major Support in case of a long trade, and above a Resistance in case of a short trade. Most of the leading forex brokers will allow you to set these stop loss levels to support your trading strategy.
Important Points to Remember About Support-Resistance
- Support and Resistance are areas on your chart (and not lines).
- The more times Support and Resistance is tested, the stronger it gets.
- Trading at Support and Resistance gives you favourable risk to reward.
- In case price breaks past a Support level, that level often transforms in to a new Resistance level. The opposite is also true. If price breaks out above a Resistance level, it is likely to find Support at that level in the future.
Knowing how demand and supply play a role in financial markets is one of the most important keys to trading success. Learning to identify areas from where prices are likely to change direction is more an art than a science. Master this one art, and you won’t need any other tool to profit from the markets. Check out some of the education sections from the top brokers for beginner traders.