September 4, 2021
man trading

Using Support and Resistance Levels in Forex Trading

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.

total assets to shares

This is an illustration of how its total assets can calculate share value, but this doesn't suggest an accepted and reliable method of share value calculation.

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.

support level

Support levels are marked by the blue horizontal line underneath the prices. It shows a level where prices have parked for some period of time and then sprung right back up.

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.

resistance level

Resistance levels are marked by the red horizontal line above prices. The longer horizontal line on the left of this image shows how that Resistance level broke and brought in a more significant Resistance area marked by the horizontal line on the right. 

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?

gbpusd resistance

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.

diagonal-support-line-on-eurusd-chart

A diagonal support line is drawn on the EUR/USD daily chart. (Resistance lines can be drawn using the same approach, but the diagonal resistance line on a downtrend is above the prices.)

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.

Trading Tips:

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.

CANDLESTICK HIGH AND LOW

Highs and lows are identified by the wicks above or below the body of a candlestick. 

Therefore, highs and lows should also be taken into account when marking zones on the chart.

Example

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.

audusd price levels

Click to zoom

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.

Trading Tips

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:

  • For a breakout to occur, momentum may be critical and can be represented by a run-up on volume or a string of long and seemingly more vigorous candlesticks.
  • The price patterns which are formed by clusters of candlesticks can also offer clues for the possible direction of prices as they relate to SR levels too. Studying patterns like triangles, wedges, channels, and others provide a more comprehensive analysis and are discussed in another article.
  • Trading the trend is also important to note as well as what the fundamentals dictate. Tactfully riding a price trend -- which is a general direction of prices that are predicated by fundamentals -- positions a trader to a trade setup with a better chance of succeeding as trends can last a for months to years.

Recap

  • Technical Analysis provides a method for traders to analyze data from price patterns, trends, and trading volume, which allows them to forecast future movement.
  • Support and Resistance Trading is a component of TA that determines how prices may react to certain levels it had visited before.
  • Drawing Support/Resistance lines can be best achieved by initially using a line chart, but highs and lows shouldn't be neglected.
  • There are two ways traders can trade S/R zones: trade the breakout or the bounce.

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.

7 thoughts on “Using Support and Resistance Levels in Forex Trading

  1. Wow! Great article on forex trading

    I have traded forex before but that have little on no knowledge on technical analysis, I always buy signal. I don’t really understand what is support and resistance…I tried but couldn’t get my hand on it. But with the pictorial explanation in this article 8 think I understand it… I will give it a trial again. Thanks so much for this information.

  2. Thank you for today’s lesson on forex trading. I can very well say that I have learnt a great deal from all the lessons that I have gotten from your website here. I now understand properly what using support and resistance is. I bought and ebook for forex trading that did not explain what it meant in details. Thanks for sharing.

  3. Your Article on Support and Resistance is very great and simplified. I am not actually in Forex Trading but I understand that  it present more simplified way of analyzing future price movements will make prediction to be more accurate and that is amazing. I will love to forward this Site to our family Friend that is into Forex Trading. Thanks for the Post.

  4. Hi there,  this is a very interesting review. I find it helpful and supportive. For me technical  analysis has helped me a great deal in trading better but then I’ve never really applied the support and resistance technique of trading in Forex. Reading your article has really broaden my knowledge in Forex trading as I will look forward to applying this knowledge in my trading.

  5. Hi there, Thank you for such an informative article. Support and Resistance is a tool used by Forex Traders to make decisions on when to trade on the bounce or breakout. Using a linear line and observing the high and low should not be ignored. I am familiar with various techniques used to assist traders when to make a buy or sell. Traders analyze data such as price patterns, trends, and trading volume, which allows them to forecast future movement. These are all elements of Technical Analysis. I was a short term money market dealer in the 80’s just before the World Recession in 1988. Finding new and innovative ways to analyse market movement is crucial to the profit margins for the Traders clients. In the 80’s we used basic current market spending patterns to analyse future movement and that was all. These are much more sophisticated techniques that help Traders maker smarter choices for their client and for their own accounts. Thank you for the informative article. Jen

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