What is support and resistance in trading?
February 23, 2021 2021-04-18 20:32What is support and resistance in trading?
Support and resistance are two of arguably the most important concepts in technical analysis and trading. They’re price levels or areas of price that act as a barrier for the price. Depending on the direction of the market will determine whether the barrier is a support zone or a resistant zone.
A key concept of support and resistance is that one can turn into another. Should the price approach a support level and breakthrough, that support level turns into a resistance level. It can therefore be used as a place to look to sell.
The concept of support and resistance is relatively simple, but sometimes using this knowledge can be difficult.
Support explained
A support price level is always below the price. It is a barrier that will stop the price moving any lower. This is where you would expect demand to increase and buyers to start buying. As buyers start buying, this will help prevent the market dropping below the support level.
Support levels act as a floor for market prices and encourage the market to bounce and move higher.
Support levels are where traders look to buy. Anything above the support is an opportunity to buy.
Resistance explained
Resistance is the opposite to support. This is found above the price and acts as a ceiling, stopping the price from going above. This is where supply increases and demand decreases and where you will start to see sellers entering the market. When sellers enter, this stops the market from going any higher and above the resistance level.
Resistance levels are where traders look to sell. Anything below the resistance is an opportunity to sell.
How many levels of support and resistance are there?
There are lots of support and resistance levels in the market. They can be found on any time frame and be relevant at any time.
If you’re looking on a daily time frame then you won’t be able to see the support and resistance levels that are visible on a 15-minute time frame. You also wouldn’t want to look at these because there would be too many to know which ones are likely to hold.
Initially, one of the most challenging things about support and resistance is knowing when to use and on what time frame. We’ll look at this a bit closer in this lesson.
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How to identify support and resistance levels
Identifying support and resistance levels is a discretionary skill however there are some ways that help remove that element of discretion.
There are lots of ways to identify support and resistance levels therefore it’s important that you decide which way works for you and stick with it. Consistency is key to your trading strategy.
Below we take a look at some of the best ways to identify support and resistance levels.
- Price swing highs and lows — When a market trends it creates significant swing highs and lows. These highs and lows are the market showing you that buyers or sellers have entered the market here, therefore this is evidence of support and resistance. The most recent highs and lows are also more likely to hold compared to older highs and lows. See the example below to identify support and resistance levels using swing highs and lows.
- Impulse levels — Impulsive market moves are also a good indication of where support and resistance levels are. This is because the market has shown that in order to get through this level it has needed significant momentum, therefore any move back to it, you would expect the buyers or sellers to still be there and wanting to enter.
- Round numbers — Round numbers are also seen as key support and resistance levels, for example, 12,000 or 1.5000. There are two main reasons for this:
- Psychological — A big reason is simply that human beings like round numbers. You will often find traders take profit and stop-loss orders close to these levels, which in turn turn them into support and resistance levels.
- Option strikes — Options are derivative products. The strike price is an agreed price to buy or sell that derivative product. Often this tends to be at round numbers and a reason why they act as support and resistance levels.
The methods above are simple ways to identify support and resistance levels but there are lots of different ways you can identify these levels.
- Trend lines and channels — These are lines in the market that have proven to hold the market price. Should the market test these lines several times and they hold, then you can use them in the future as a place where the price might continue to hold. If the trend line is acting as support but the price breaks through, then the trend line can then be used as resistance and a place to look to sell.
- Pattern lines — We’ll have a deeper look at price patterns but they’re also a great place to identify both support and resistance levels. They’re dynamic and will occur wherever the price pattern happens.
- Moving Averages — Moving averages are a dynamic way of identifying support and resistance. Like any average, the price will always come back to it, therefore when it does it often acts as a support or resistance level. If the price breaks through the moving average, then support turns into resistance or vice versa. We’ll cover moving averages in our moving average lesson.
- Fibonacci retracements and extensions — You can use Fibonacci numbers to project market retracements and extensions. These levels can be used as support and resistance levels. We look at this topic in more detail here but because these levels aren’t directly associated with the price, they’re considered to be a secondary method of identifying support and resistance levels.
- Bollinger Bands — These are an advanced way of looking at moving averages. They’re the standard deviation of the moving averages, both above and below the price. Similarly, they’re considered a secondary indicator but they can also act as support and resistance levels.
- Pivot Points – Pivot points are created using a mathematical formula and were originally used by pit traders when they were trying to determine the previous day’s significant levels. Again they would be secondary but are a very common way of identifying support and resistance.
How is support and resistance used in trading?
When you’re trading, you use support and resistance levels for two main reasons:
- To identify whether a market is trending or ranging.
- To identify key levels where you can look to enter or exit your trade. They’re often used for stop loss and take profit placement (although not directly on these levels).
A really important thing about support and resistance when using it to enter and exit trades is that you should not put your order directly on the level.
This is because the price will test these levels before rebounding. When placing your stop loss, you should always be looking to place it either side of the level.
If you’re buying, then your stop loss should be below a support line. This is because if that support level holds, then you won’t get stopped out and the level did its job. The same applies if you’re selling, you would place your stop loss above the resistance level.
If the market breaks above that level, then this would signal to you that your analysis was not right this time and it is best for you not to be in the trade.
How do you calculate support and resistance?
You don’t tend to calculate support and resistance levels in trading unless you’re using a technique like Fibonacci or pivot points.
Traditionally you’ll identify them by eye on a chart, hence why it can be a discretionary skill.
There are some tools that can calculate automatic support and resistance levels for you, and these are good because they’re consistent.
Pivot points are the most common type of support and resistance levels that use calculations.
What is pivot point trading?
Pivot points are levels identified by simple mathematical calculations. You need three inputs from the previous day for the calculations; the previous days high, low, and closing price.
Using these, you can identify several support and resistance levels for your trading strategy.
The calculation is as follows:
Pivot point (PP) = (high + low + close)/ 3
Resistance 1 (R1) = (PP × 2) − low
Resistance 2 (R2) = PP + (high−low)
Support 1 (S1) = (PP × 2) − high
Support 2 (S2) = PP−(high−low)
Lots of trading platforms now offer pivot points as an automatic indicator, which means you won’t need to actually do the calculations yourself.
A popular day trading strategy when using pivot point levels is to buy or sell depending on where the price is at the start of the day in relation to the pivot points.
- If the market starts above the pivot point (PP) or moves above it early in the day, you can look to buy it and take it up to the next resistance level (R1).
- If the markets move below the Pivot Point (PP) in early trading, you’d decide to sell.
This isn’t the only way you can use pivot points. You can use them in conjunction with other indicators or levels to create clusters. These clusters become more significant areas of support and resistance and become a place of higher probability that the price will hold there.
If you can combine a pivot point with a swing high and a Fibonacci extension, there is a higher chance that the price will hold there. Therefore, creating a great place to buy or sell.
How to draw support and resistance lines
You draw traditional support and resistance levels by using a horizontal line and place it on the price you have identified as the significant level. You can do this on the levels we highlighted above like swing highs and lows or round numbers.
If you’re drawing a trendline to act as a support line, then you would identify three significant swing lows and draw the line connecting them all. We will look at this in more detail in our trendline lesson. Lines like this are dynamic and will change according to the price.
Support and resistance strategy
There are lots of ways you can build a trading strategy using support and resistance. It is considered to be a primary indicator and therefore can be used on its own however like most trading strategies, using them in conjunction with other indicators often gets the best results.
As we mentioned above, finding clusters are a great way to find high probability setups.
Here is an example support and resistance strategy you can use and adapt.
- Identify major key support and resistance levels using swing highs, lows and round numbers.
- Identify the direction of the market by looking at the last two levels the price has broken through.
- Add pivot points to find a cluster zone.
- If the market is moving up, look to buy when the market approaches support clusters.
- Buy just above the support zone.
- Place your stop loss just below the support zone or a support zone further away.
- Place your take profit order just below the next resistance zone.
In our next lesson, we look at chart patterns.
