Support
and resistance is one of the most widely used concepts in trading. Strangely
enough, everyone seems to have their own idea on how you should measure support
and resistance.
Let's
take a look at the basics first.
Look at
the diagram above. As you can see, this zigzag pattern is making its way up
(bull market). When the market moves up and then pulls back, the highest point
reached before it pulled back is now resistance.
As the
market continues up again, the lowest point reached before it started back is
now support. In this way resistance and support are continually formed as the
market oscillates over time. The reverse is true for the downtrend.
Plotting Support and Resistance
One thing to remember is that support and resistance levels are not exact numbers.
Often times you will see a support or resistance level that
appears broken, but soon after find out that the market was just testing it.
With candlestick
charts, these "tests" of support and resistance are usually
represented by the candlestick shadows.
Notice
how the shadows of the candles tested the 1.4700 support level. At those times
it seemed like the market was "breaking" support. In hindsight we can
see that the market was merely testing that level.
So how do we truly know if support and resistance was broken?
There is
no definite answer to this question. Some argue that a support or resistance
level is broken if the market can actually close past that level. However, you
will find that this is not always the case.
Let's
take our same example from above and see what happened when the price actually
closed past the 1.4700 support level.
In this
case, price had closed below the 1.4700 support level but ended up rising back
up above it.
If you
had believed that this was a real breakout and sold this pair, you would've
been seriously hurtin'!
Looking
at the chart now, you can visually see and come to the conclusion that the
support was not actually broken; it is still very much intact and now even
stronger.
To help
you filter out these false breakouts, you should think of support and
resistance more of as "zones" rather than concrete numbers.
One way
to help you find these zones is to plot support and resistance on a line chart
rather than a candlestick chart. The reason is that line charts only show you
the closing price while candlesticks add the extreme highs and lows to the picture.
These
highs and lows can be misleading because often times they are just the
"knee-jerk" reactions of the market. It's like when someone is doing
something really strange, but when asked about it, he or she simply replies,
"Sorry, it's just a reflex."
When plotting support and resistance, you don't
want the reflexes of the market. You only want to plot its intentional movements.
Looking
at the line chart, you want to plot your support and resistance lines around
areas where you can see the price forming several peaks or valleys.
Other interesting tidbits about support and
resistance:
·
When the price passes through resistance, that resistance could
potentially become support.
·
The more often price tests a level of resistance or support
without breaking it, the stronger the area of resistance or support is.
·
When a support or resistance level breaks, the strength of the
follow-through move depends on how strongly the broken support or resistance
had been holding.
With a little practice, you'll be able to spot potential support
and resistance areas easily. In the next lesson, we'll teach you how to trade
diagonal support and resistance lines, otherwise known as trend lines.
