A Quick Fundamental Overview
Support and resistance are among the few most important concepts in technical analysis, as they are absolutely crucial for interpreting price charts accurately. Changes in the valuation of financial instruments are driven by the interplay of supply and demand. When demand surpasses supply, prices ascend, whereas an excess of supply over demand leads to price declines. Occasionally, when supply and demand reach equilibrium, prices would exhibit a sideways movement.
Static Levels of Support and Resistance
In a downtrend, prices decline due to an abundance of supply compared to demand. As prices decrease, they become increasingly appealing to potential buyers who have been awaiting favorable opportunities to enter the market. Eventually, as prices reach a certain threshold, the demand that had been gradually building up reaches a level where it matches the available supply. This marks the point at which prices cease their descent. This phenomenon is referred to as support. The latter can manifest as either a specific price level or a price zone on the chart. Regardless, it represents an area on the price chart that reflects the willingness of buyers to engage in purchasing activity. Typically, at this level, demand prevails over supply, causing the downward price movement to pause and potentially reverse direction.
Having a look at the chart below, one can see how the AUD/USD made numerous attempts on the 0.6270-0.6285 support zone. After the last unsuccessful test of the area, the FX pair eventually reversed course and started trending up.
Resistance can be defined as the opposite of support. When prices ascend, it’s typically due to greater demand than supply. However, as prices climb higher, a point is reached where selling pressure surpasses buying interest. Various factors contribute to this scenario, such as traders deeming prices as overvalued or meeting their profit targets. This shift could also stem from buyers’ reluctance to initiate new positions at elevated price levels. A technician analyzing a price chart can readily identify a level at which supply begins to outweigh demand. This level is referred to as resistance, which, like support, can exist as a specific price level or a broader zone.
The USD/JPY chart below shows the three consecutive unsuccessful tests of the 151.95 resistance level. No matter what the future holds for the pair, the mentioned resistance is still intact and thus, closely watched by traders.
Once support or resistance areas are pinpointed, these price levels can serve as potential entry or exit points for traders. When the price approaches a previous support or resistance level, it typically exhibits one of two behaviors: either it rebounds away from the support or resistance level, or it breaches the level and continues its prior trajectory until encountering the next support or resistance level.
Some trades are executed based on the expectation that support and resistance zones will hold firm. Traders make predictions on price direction, banking on whether the price will be halted by or break through these levels. By swiftly assessing the price movement, traders can determine the accuracy of their predictions. If the price moves against their expectations (breaking through prior support or resistance levels), traders can close their positions at a minimal loss. Conversely, if the price aligns with their predictions (respecting prior support or resistance levels), the potential profit could be substantial.
Some Important Aspects to Consider
Support and resistance levels are identifiable across various charting timeframes, spanning monthly, weekly, daily, hourly and even smaller intervals like one-minute or five-minute charts. The technical significance of these levels tends to increase with longer timeframes. To identify them, traders typically examine historical price movements to locate significant pauses in either an upward, or downward price trend. Subsequently, they observe whether prices stall or reverse upon approaching these levels in the future. Many seasoned traders place trades based on past support or resistance levels, anticipating a similar market reaction at these points.
It’s important to note that technical analysis is not an exact science, and prices may occasionally dip below support levels or reverse before reaching prior support levels. The same holds true for resistance levels, where prices may reverse before reaching or break above them. Therefore, interpreting these chart patterns requires a degree of flexibility, which is why support and resistance levels are often referred to as zones. The significance of these price levels lies not in any mystical properties but rather in the collective actions of market participants, who react to the same information and place trades at similar levels.
Dynamic Levels of Support and Resistance
The examples above demonstrate how a static level can act as a barrier, restraining an asset’s price from advancing or declining. While this static barrier is a prevalent form of support/resistance, financial asset prices typically trend upward or downward, resulting in these levels moving up or down over time. Hence, understanding the concepts of trending and trendlines becomes crucial when studying support and resistance dynamics.
During an uptrend, many traders closely monitor the price of a trading instrument as it approaches the broader support of the trendline since historically, this level has prevented the asset’s price from experiencing significant declines. For this reason, this dynamic support often provides an opportunity to enter the market or add to an existing position with a pretty reasonable reward to risk ratio. To limit potential losses though one always needs to consider placing a stop loss order below the dynamic support.
During a downtrend, in contrast, traders are more focused on the price of the asset under observation as it approaches the resistance of the trendline. The reason is that the latter has often prevented the price from rallying. In this case, the dynamic resistance could potentially provide a good level to sell short, with potentially high reward to risk parameters. Again, a stop loss above the dynamic resistance here is highly recommended as a means to preserve your capital.
