Support and Resistance
The terms “support” and “resistance” are two of the most common in the lexicon of technical trading. Essentially, they refer to the price levels marking areas where, historically, buyers have entered the market (demand, support) and the areas where sellers have dominated (supply, resistance). This is most easily understood with visual aids:
These price areas are important for two reasons, one practical and one is psychological. For practical purposes, we can know by looking at a chart that environmental factors in the past have prevented buyers and sellers from violating these areas. If, in the past, the Australian Dollar has been unable to breach 0.9850 versus the US Dollar, we can assume that this was not an accident. The majority of market participants made a decision when prices reached that level. Unless the world has fundamentally changed since that point, we must assume the same activities are likely to occur.
Environmental factors likely influenced the situation, and will again. Perhaps, as an example, exports from Australia dropped because of the high value of the country’s currency. The market saw this data, and started selling. If, in the future, prices started approaching this 0.9850 resistance area, most traders would assume that it is time to start selling the Australian Dollar. If the resistance level does in fact break, market traders will start to operate under the assumption that the environmental factors have changed, the market is operating within a different atmosphere. For traders, this creates a positive underlying bias for the asset (the Australian currency). The same logic holds true for all other markets.
Psychological factors also play an important role. In the example with the Australian Dollar, does 0.9850 seem too exact to be a coincidence? It should. The reason for this lies in the fact that the market often becomes fixated on large, round numbers. If the Australian Dollar surpassed 0.9850 and started to approach parity (1 Australian Dollar to 1 U.S. Dollar), the psychological selling would likely have been even stronger.
Remember to pay special attention to the attractive power of round numbers in asset prices because these are the areas where market participants are likely to start trying pushing the market in the opposite direction. If these efforts fail, traders should expect violent reaction the other way because many market participants will be forced to bail-out on their trades.
Sometimes, however, these major levels of support and resistance break. These are the trigger signals for the “breakout” traders. Additionally, an interesting phenomenon occurs, and a common market phrase starts to become especially relevant: “support becomes resistance, resistance becomes support.” Let’s look at a chart example:
The reasoning for this occurrence is the idea that supply and demand have shifted for the asset that is being traded. In a region of resistance, once selling pressure has been overcome, those sellers will be forced to bail out on their trades. A seller exiting his trade becomes a buyer. (The opposing logic holds true for major support levels that have been broken.) Those areas will then be the places where major selling pressure will begin to unfold. This phenomenon is important to remember because it is not intuitively obvious but at the same time it is something that active traders will witness on a regular basis.
The identification Support and Resistance is thought by many to be the most important aspect of technical training for beginners because it is a highly effective way of accurately realizing that trading ranges have broken. The breaking of a range can be one of the first signs that a trend is changing and market bias has reversed. If a trader truly hopes to “buy low and sell high,” the first step is to realize that an uptrend or downtrend is beginning its reversal. Below, is an example:
Last, we will look at some notes of caution. Using the 0.9850 level in the Aussie Dollar as an example we should consider which areas would be dangerous in terms of placing a trade entry. If prices again began to approach this resistance level, some might think that placing a sell order at 0.9850 would allow for the maximum potential profit. While this idea could feasibly bring the greatest gains for the trade, this is not necessarily the safest area for entry. Why? One word: Volatility. Large amounts of buy and sell orders are placed at major areas of support and resistance, and with all the market makers and traders involved in the modern trading environment, entries that are this precise cannot be guaranteed. The safest method is to place your order entry a few ticks inside the support or resistance level.
There are no guarantees in this business and it is impossible to predict exactly which number will mark the high or low. To be on the safe side, it is better to sacrifice a few points and decrease the possibility that the trade will accrue unnecessary losses.