What is support and resistance (S&R)?
Support and resistance zones are very important technical indicators in technical analysis. Integral to any financial market, support and resistance levels essentially represent demand and supply – the order flow – which can rapidly shift.
Support and resistance indicators show some predetermined levels at which the market’s price is expected to stop and reverse. This widely followed technical analysis technique helps to quickly analyse the price chart and to determine the 3 key points, which are extremely important to traders:
The market’s direction
The time to enter the market
The points to exit the market
Support is a level where the market price tends to find support as it falls. At this point the demand is strong enough to stop the price from falling further. It means that having reached this level, the market’s price will more likely to bounce off rather than break through it and continue falling. However, the price may still break through the support level and continue its downward movement until meeting another support level.
Resistance is the opposite of support. At this level the supply is strong enough to stop the price from rising further. It defines where the price will encounter resistance as it rises. The same as with the support level, the price may be likely to push away from this level rather than break through it. However, if it happens, the price is likely to continue moving up until facing another level of resistance.
The concept of support and resistance consists of the support level, the “floor” under trading prices, and the resistance level, the “ceiling”. In this case, a trading instrument is like a rubber ball, which is bouncing in a room. It hits the floor (support) and rebounds off the ceiling (resistance). The ball here, i.e. a trading instrument, experiences consolidation between support and resistance zones.
Who invented support and resistance?
Many of the major technical indicators were described as early as 1930 by Richard W. Schabacker, who became famous due to his pioneering research in technical analysis. His work “Technical Analysis and Stock Market Profits” is a prime example on the theme.
Richard W. Schabacker presented technical analysis as a totally organised subject and laid out various important patterns, including support and resistance areas.
Psychological levels of support and resistance
The backbone of technical analysis, support and resistance levels may also depend on human psychology. For example, when the price ends with several zeros, it is usually called a “psych” level.
People tend to gravitate towards round numbers. When we discuss the future value of a particular stock or currency, we won’t say something like 1.1046 – we’d likely round off our forecast to something simpler, like 1.1000.
As a result, we’ll probably see a whole cluster of orders around these round numbers, which create stronger levels of support and resistance.
The most common psych levels often happen when the price ends up with 2 or even 3 zeros, for example 1.600, or 15.000. The strongest psychological levels end up with four zeros, for instance, 100.0 or 1.0000.
Fibonacci support and resistance
Fibonacci numbers, the work of 13th century Italian mathematician Leonardo Fibonacci, have been a popular ingredient in creating different technical indicators, including support and resistance.
A series of Fibonacci numbers – 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 – are often used in order to calculate entry points while trading stocks, commodities and forex during the market trends.
Fibonacci retracement numbers are used to indicate entry points and targets during the trending markets – they mark the reversal spots, where traders may catch entry points during retracements in the trend. If the market is uptrending, you use Fibonacci numbers from bottom to top. In a downtrending market, you use them from top to bottom.
Why is support and resistance useful for traders?
Serving as one of the key concepts of technical analysis, support and resistance levels form the basis of a wide range of technical analysis tools. Determining the future level of support may help to improve investment returns, because it provides traders with an accurate view of the price level that should prop up the asset’s price. Vice versa, foreseeing the resistance level may also be beneficial, as it serves as a price level, which can harm your long position – specifying the area where investors show willingness to sell the instrument.
There are numerous methods to identify support and resistance levels, but the interpretation remains unchanged: support and resistance indicators potentially identify the price of an underlying asset moving in a particular direction. This primary technical analysis tool is used as a way to predict the asset’s price movement and enable traders to point out potential buy and sell spots.
Technical analysis: how to trade with support and resistance?
How to use support and resistance in trading? Here’re the top 4 support and resistance trading strategies:
Range trading occurs within the area between support and resistance lines as traders aim to buy at the support level and sell at the resistance level. Note that support and resistance do not always represent perfect lines. Sometimes there will be some noise around, rather than a perfect line. Traders have to identify a trading range – i.e. the areas of support and resistance.
Traders are trying to find long entries, when the price bounces off the support level, and are looking for short entries, when the price stands near the resistance level. You should also remember that the asset’s price may violate these boundaries, that is why you should consider placing stop-losses below support when going long, and above resistance, when going short.
After a period of uncertainty, the price often breaks out and starts a new trend. Traders usually try to catch these breakouts below support level and above the level of resistance in order to profit on the potential further momentum in one direction.
However, traders shouldn’t act prematurely. For example, the price dropped down below the support level. Many traders rushed to go short immediately. Instead, traders usually wait for the market’s response (a pullback towards support or resistance) to break down before catching a longer downward momentum.
The trendline trading strategy suggests to use a trendline as either support a resistance. Traders simply draw a line, which connects several highs in a downtrend, or several lows in an uptrend. If the trend is strong, the price would bounce off the trendline and continue its movements in the trend’s direction. In this case traders pick up entry points in the direction of the trend.
Moving averages trading
Moving averages can also be used as dynamic support and resistance. Traditionally, the popular moving averages are 20 and 50 period MAs, though they can be slightly altered to 21 and 55 respectively (to make use of Fibonacci numbers).
From the example above, you can see that the 55 moving average initially stood above the market, representing the resistance line. When the market reversed, the 55 MA started acting like a dynamic level of support. These lines help traders to define, whether the market is likely to continue the current trend or is close to a breakout.