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Saturday, July 11, 2009

Bursa Chat Weekend School- Support & Resistance

Support and Resistance in Trading

5.1. What are Support and Resistance?

Support is the price zone below the current price where price declines are likely to stop and reverse. Resistance is the prize zone above the current price where price advances are likely to stop and reverse. In an uptrend, price advances (price thrusts) are blocked by resistance and price declines (price reactions) are stopped by support. In a downtrend, price declines (price thrusts) are blocked by support and price advances (price reactions) are ended by resistance. When prices breaks through resistance they can be expected to rise up to the next level of resistance. If price breaks through support you can expect it to fall down to the next level of support.

For an uptrend to continue, each successive price thrust should be able to break up through the level of resistance which stopped the previous price thrust and each price reaction must complete at a higher support level than the previous price reaction (violation of this rule leads to the top price reversal patterns like the head and shoulders). For a downtrend to continue each successive price thrust should be able to break down through the level of support which stopped the previous price thrust and each price reaction must complete at a lower resistance level than the previous price reaction (violation of this rule results in the bottom price reversal patterns like the double bottom).

support resistance uptrend downtrend

support resistance uptrend

Click to Enlarge. Chart Source - ProCharts.

Click to Enlarge. Chart Source - ProCharts.

5.2. Measuring Support and Resistance

Support and resistance levels are calculated based on how prices behaved at specific times in the past and also on how prices tend to behave in general. If currency price failed to break through a certain level in the past, this level can be expected to block price movement in the future. If currency price as a rule finds support or resistance at certain technical analysis tool positions, this can also be used to predict price behaviour when these positions are reached. Strongest support and resistance are produced when both measurement methods point in the same direction.

ALL of the technical analysis tools can be used to identify support and resistance. You can expect trendlines, moving averages and Bollinger bands to support the prices when they are below the current price and to resist the prices - when they are above the market. Bullish indicator signals will regularly point to support and bearish oscillator signals will frequently indicate resistance. Fibonacci retracements will often act as support in uptrends and as resistance in downtrends. Fibonacci projections and price channel projections will normally provide resistance in uptrends and support in downtrends. Candlestick patterns will usually be the first ones to indicate important support and resistance levels. Round number price levels (e.g. 1.2850, 1.2900 and 1.3000 for EUR/USD) also tend to act as support and resistance. The more zeroes a price level ends in the stronger it can support or resist the prices.

different tools confirming support

Click to Enlarge. Chart Source - ProCharts.

different tools confirming resistance

Click to Enlarge. Chart Source - ProCharts.

Note: Most forex newswires regularly broadcast major support and resistance levels closely watched by the professional forex trading community - including those levels which are not easily identified by the standard analysis methods (e.g. option barriers, large clusters of buy or sell orders). Technical commentaries distributed by the investment banks also provide reliable information on important support and the resistance levels.

5.3. Role Reversal between Support and Resistance

Support becomes resistance when the prices penetrate it by significant amount - and vice versa. You can see this rule in action if you review how some of the dynamic trends are developing. Most of the times the resistance which blocked previous price thrusts in an uptrend will become support to subsequent price reactions once it has been violated. In a similar fashion, the support which obstructed earlier price thrusts in a downtrend will become resistance to later price reactions after it has been broken. This principle is behind the third rule of impulse wave identification - namely, that wave four cannot move past the end of wave one.

This rule is applicable to most technical analysis tools. An up trendline can be expected to resist price advances after it has been broken to the down-side. A moving average which formerly acted as resistance will start to support price declines if it is decisively penetrated. Fibonacci retracement of a previous uptrend which supported the prices will turn into resistance on subsequent tests if it is violated. A round-number level previously serving as support will become resistance to future price advances when a currency pair breaks below it.

5.4. Strength and Probability of Support and Resistance

The strength of support or resistance depends on how many times it was successfully tested in the past and on its scale. An up trendline drawn from a multi-year bottom which supported the price five times during the last year is much stronger than a down trendline drawn from a one-month-old peak and which contained only two minor pullbacks. The Bollinger bands visible on the daily charts will exert greater influence on the prices than the Bollinger Bands visible on the hourly charts. A currency price level which terminated two intermediate uptrends in the last few months is far more important than the most recent high which blocked only one minor uptrend.

Probability of a future support area depends on the combined strength of all the tools which identify it. The same applies to probability of a future resistance area. The more technical tools of different scale and type coincide in one price zone the higher the probability that this zone will serve as important support or resistance area. This happens because different market participants use different technical analysis tools and time-scale charts to identify favourable entry and exit points. When dissimilar tools used by separate groups of currency traders give the same signal the chances increase that unified response by all these traders will forcefully move the market in one direction. I will note that there will be many potentially profitable trading setups which are identified by only one type of technical tool (e.g. a trendline). One of the ways you can handle such situations is to determine the size of your positions based on the strength of the technical signal (s) which define support or resistance levels, as is described in the forex trading system page.

Examples of the combination of the same type but different scale technical tools reinforcing each other's signals are - intersection of major and intermediate down trendlines, clusters of fibonacci retracements draw from different-length price swings and completion of minor impulse waves at the end of intermediate impulse waves (also known as the fifth of the fifth).

Examples of the combination of the different type tools confirming support:

Convergence of a 50% fibonacci retracement of the previous price thrust in an uptrend, an up trendline, bullish RSI divergence, a hummer penetrating the lower Bollinger band and a round price level.

100-day simple moving average coinciding with the broken major down trendline now acting as support and Stochastic turning from the oversold territory.

Examples of the combination of the different type tools confirming resistance are:

Price channel projections of the intermediate and the minor trends meeting at a major round-number price level.

Confluence of a 61.8% fibonacci retracement of the first three waves in a downward impulse sequence, a down trendline and a Stochastic turning dwon from the overbought territory

Meta4: High probability trading setups can be compared to beautiful works of art. If you examine the paintings of any recognized master you will discover that the brush strokes that the artist laid on the canvas - even they differ in width and color - tend to compliment and reinforce each other's effect, each in its own way contributing to the beauty of the whole picture. In a similar manner, high probability support and resistance zones are virtually painted when technical tools of different scale (i.e. width of the brush strokes) and type (i.e. color of the brush strokes) converge harmoniously in one price area, confirm each other's signal and thereby reveal outstanding profit opportunities. The trading method which combines different type and scale technical analysis tools to find high probability trade entries and exits is called synergetic trading.

Quote: "Currency forecasting, like all forecasting of financial markets is the art of the possible.", John Percival in his book "The Way of the Dollar".

As with true appreciation of the art which takes time to develop, trading experience is required to master the skill of identifying high probability trading setups when they are developing. Even if understanding of artistic beauty is highly subjective in general, it is possible to objectively measure the beauty or probability of promising entry or exit setups - by using a predefined support and resistance ranking system.

Note: One of the ways to learn how to combine different tools to identify high-probability trading setups is to study technical analysis reports created by in-house technical analysts of investment banks and forex newswires. Some of the forex newswires also regularly post market commentaries made by outside technical analysts working for the major investment houses. These commentaries are especially valuable sources of practical insight on how to combine different types of technical analysis tools in currency trading.

5.5. Mastering Support and Resistance in Currency Trading

You can greatly increase accuracy of your trading if you concentrate on executing your trades at high-probability support and resistance areas. It is important to be prepared for these price zones well in advance - so that you can act with confidence when the price approaches them. This task is best performed if you have ALL of the technical analysis tools in front of your eyes, plotted on the charts of each of the three degrees of the trend. To eliminate possible confusion, you should specify in your forex trading system which technical tools you will use to identify future support and resistance and which combinations of the signals generated by these tools will warrant opening and closing of your trading positions. You can also use a daily checklist to help you recognize those moments when any of your technical tools is close to or is in the process of giving its signal.

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