One of the two types of analysis that traders utilize to trade the forex market is technical analysis. Technical Analysis involves the study of prices, patterns, and price movement. And although this article will cover only the basics of support and resistance levels in forex trading, this component of price analysis is also applicable to other tradable instruments like stocks and commodities.
Why Use Technical Analysis?
Thanks to the assets a company owns, the revenue it generates, and the cash flow it produces, there's a way for investors to determine a reasonable stock price mathematically.
For instance, all the machinery, raw materials, equipment, finished products, and other assets owned by a company can be appraised to arrive at a rough estimate for what each share the company has issued is worth.
Currencies, on the other hand, are merely a representation of purchasing capacity -- no revenue, no cash flow, and no ownership of anything. So, to employ the same method for valuing stocks to currencies, would be inapt.
This is where technical analysis fits into place as it offers a method for predicting how likely a currency pair trades by analyzing historical foreign exchange prices.
But that’s just a fragment of the broader subject that is technical analysis. In fact, historical prices are also an ingredient for some technical indicators (calculations intended to forecast the possible direction of prices).
Defining Support and Resistance
Technical indicators are another subject, and each one deserves a full-length article because some of them tackle a great deal of complexity with the math involved.
Support and Resistance trading presents a more simplified way of analyzing future price movements and is, in fact, very foundational to the subject of technical analysis.
Support and Resistance are levels on the chart, signifying key areas where prices have visited in the past.
Support is best described as the point where selling pressure comes to a halt with the presence of some buying momentum that is resilient enough to reverse the prevailing downward trajectory of price.
In other words, Support is the floor for falling prices.
Conversely, Resistance is the point where buyers pull back, and selling momentum picks up, i.e., it's the ceiling for the upward direction of prices.
Studying Support and Resistance offer investors some perspective on how these price levels can be traded.
For instance, how would the GBP/USD react to the Resistance zone (a zone isn't determined by a specific price but by a range of prices between two levels) depicted by the yellow-orange rectangle on the picture?
Or, if the GBP/USD trades lower, how would it feel about the 1.2477 support?
How To Draw Support and Resistance
Although there are some guidelines that technical analysts have put together, drawing Support and Resistance is still not an exact science.
What's important when drawing horizontal or diagonal lines is to make sure that the price level is significant to the market.
Several touches of price can identify the significance of a price level to that same zone -- a single contact may not be as pertinent as two or more.
Some experienced traders recommend switching to line charts initially to draw SR on closing prices.
The rationale for doing this offers many explanations from "closing price is the most relevant" to "it's the price that the market decided to settle at during a specified period."
But since the market moves round the clock for five straight days, closing prices would be more meaningful if it envelops weekly data or if it pays close attention to the close of the US trading session, which is 4 pm ET.
Therefore, highs and lows should also be taken into account when marking zones on the chart.
The chart of the AUD/USD below shows a Support zone turned Resistance zone from 0.7334 to 0.7355. A similar case can be found on the 0.7180 level as with the other lines beneath it.
The lowest Support level on this chart is at 0.6865, which could eventually turn to Resistance if the price sinks further from that level.
Ways To Trade Support And Resistance
Two scenarios could play out when the price hits either the Support or Resistance areas: a breakout or a bounce.
A breakout happens when price pierces through the Support and Resistance zone and manages to trade above or below it. A breakout is an opportunity for a trader to capitalize on a move that carries momentum after breaking past a zone.
A bounce is when the price ricochets from a Support/Resistance zone (e.g., buying pressure forces price to "bounce" back up from a Support line or sellers forcing the price to recoil from the Resistance area).
Trading a bounce would mean taking a trade that rides the rebound at the Support/Resistance zone, and that's with an assumption that the market will respect that area.
While it could be tempting to trade the zones on the chart, a trader must keep in mind that the name of the game is "probability." Traders should be able to draw on the number of factors that tip the probability of a successful trade to their favor.
For example, if a currency pair shows more of a bearish bias based on several technical factors, then there's a higher probability of price heading lower. Therefore, sell trades would make more sense.
So, if a support level is reached by falling prices, either a sell trade on the break below that level or a sell on the rebound in the immediate resistance would be more viable trade setups.
Patterns and Formation
Some of the things to consider are also price patterns and the size and quality of candlesticks.
Dealing with probability:
Use Support and Resistance on a Backtesting Software
One of the best ways to learn how to use any technical tool is to try and test them on a demo account or a backtesting software.