The price of financial assets is determined by forces of demand and supply, just like in any other trading market. In financial markets, it is support and resistance levels that accurately illustrate how the supply and demand forces interact to determine the prevailing price of an underlying asset.
Prices usually rise until the supply outstrips demand and that is the point of resistance, where prices will start going down. Similarly, prices will fall until demand outstrips supply and that is the point of support, where prices will start going up.
The basic strategy in the market is to buy an asset when prices are at the support level and to sell when prices are at the resistance level.
It is important to note that support and resistance levels are not exact price points, but rather zones where demand and supply can change. Support and resistance levels are closely monitored by market participants, who are all keen to take advantage of opportunities that may arise when supply or demand changes.
Types of Support and Resistance
Fixed Support and Resistance Levels
These are support and resistance levels that are fixed and cannot change. They will only be invalidated if prices manage to break above or below them. Psychological and sentimental levels, such as round numbers or previous important price points (such as all-time highs and lows), are examples of fixed support and resistance levels.
For instance, in stocks, round numbers, such as $100, can provide support or resistance to an asset price. While commodities trading, rates such as $2,000 for the gold price can be considered a support or resistance level.
Dynamic Support and Resistance Levels
As the name suggests, these are support and resistance levels that change as the price and time change. These levels imply that prices are subject to new forces of demand and supply. Technical indicators, such as Moving Averages and Bollinger Bands, create dynamic support and resistance levels as the price and time change.
Semi-Dynamic Support and Resistance Levels
Semi-dynamic support and resistance levels also change as time and price change, but they change at a fixed or predetermined rate. Some of the indicators that plot semi-dynamic support and resistance lines are Trendlines, Fibonacci Tool and Pivot Points. These indicators plot support and resistance lines that change methodically as time and price change.
Here are some of the ways to find support and resistance levels in the markets:
- Peaks and Troughs
This is the most straightforward way of plotting support and resistance levels. Simply mark visible highs and lows on your chart; the higher highs and lower highs will serve as resistance levels, whereas the lower lows and higher lows will serve as support levels. It is always recommended that these lines are marked on longer timeframes to have reliable support and resistance levels.
- Fibonacci Levels
The Fibonacci indicator can be used in two ways: Fibonacci retracements help traders identify the best entry points when a trending market is retracing; whereas Fibonacci extensions help traders identify the most optimal target points of a trending market. In an uptrend, Fibonacci retracement lines will act as support lines, whereas in a downtrend, they will act as resistance lines. On the other hand, Fibonacci extension lines will act as resistance lines in an uptrend, and support lines in a downtrend.
- Pivot Points
The Pivot Points indicator uses the open, high, low and closing prices to mathematically derive multiple lines that serve as support and resistance levels in the market. The indicator plots 7 lines: 1 pivot point (PP), 3 support lines (S1, S2 and S3), and 3 resistance lines (R1, R2 and R3). If a support line is breached, it turns into a resistance line, and vice versa. For instance, if there is an uptrend and the asset price breaches R1, the line will now act as support.
Trendlines form the foundation of technical analysis and can help traders trade with the trend. In an uptrend, a trendline is drawn from one particular low, connecting other higher lows and projecting the line into the future. The line then acts as a semi-dynamic support line.
In a downtrend, a trendline is drawn from one particular high, connecting subsequent lower highs and projecting the line into the future. The line then acts as a semi-dynamic resistance line.
How to Trade with Support and Resistance
Here are some of the online trading strategies using support and resistance levels:
This is a strategy for trading sideways or range-bound markets. These are markets that do not have a clearly defined trend and prices tend to oscillate between areas of support and resistance. The basic idea in a range-bound market is that there is a visible high where rising prices will face resistance and turn lower, and a visible low where prices will find support and turn higher. The strategy is, therefore, to look for buy trades when prices are near the support level and sell trades when prices are near the resistance level.
As mentioned earlier, support and resistance levels are zones and not specific price points. It is, therefore, important to identify the most optimal entry and exit points that will minimise risk and maximise profit potential. This can be achieved by combining support and resistance levels with other technical analysis indicators. To start with, the ADX indicator can be used to confirm that a market is indeed range-bound when the reading is below 25. Traders can then validate support and resistance signals using Oscillators, such as RSI and Stochastics; where they will sell when a market is overbought and buy when a market is oversold.
Support and resistance levels do not hold the price hostage. That means, they can be breached. Prices usually breakout after a prolonged period of consolidation, and this offers traders a great deal of opportunity.
A breakout is usually the start of a new trend, which means traders have an opportunity to ride out an entire trend from its very beginning. When the price breaches a support line, it implies that a downtrend is now in place and traders should look to place sell orders; whereas a resistance line breach implies an uptrend is in place, and traders should look to place buy orders.
When trading this strategy, the danger is usually fake breakouts, where the price only breaches a support or resistance line for a short period or the price simply makes a spiky move and returns to previous conditions.
To avoid this, it is important to validate a breakout using momentum indicators, such as ROC and MACD. A directional move will likely be sustained if the price breaches a support or resistance line with massive momentum i.e. it is a valid breakout. A fake breakout is one that happens with low momentum and should be avoided.
Support & Resistance main FAQs
- Which time frame is best for support and resistance levels?
There’s no ‘best’ time frame for finding support and resistance levels. Traders can use whichever time frame works best with their trading style and strategies. The same trader might use a four-hour chart for one strategy and a weekly chart for another strategy. In general a long-term trader will use daily to monthly charts, a swing traders could use anything from a 4-hour chart to a weekly chart, a day traders would use time frames from 15-minutes to daily charts, and a scalper would use charts from four-hours down to tick charts that plot every tick in the market.
- What are the best tools and indicators for support and resistance trading?
Again, there are no ‘best’ tools, but there are tools that each trader will favour in their own trading strategies. Fibonacci levels are one very popular set of indicators used widely in determining support and resistance. Many traders also make heavy use of moving averages when determining support and resistance level, and pivot points are also quite popular. Also used heavily for determining support and resistance levels are the price bands such as Keltner Channels, as well as other types of trend lines and channels.
- How important are round numbers as support and resistance?
One of the more interesting and noted aspects of support and resistance is the inability of price to move through round numbers such as $20 or $50. Of particular importance are the large round numbers such as $100 or $1,000. This phenomenon occurs because many inexperienced traders tend to buy when prices are at whole levels because they seem to think assets are most fairly valued when they reach these levels. Also, most stop and limit orders placed are at round numbers. It’s more likely to see a stop or limit order at $100 than at $100.06. With so many orders being placed at the same level, these levels come to act as strong price barriers.
** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.