Wednesday, July 3, 2013

How to Identify Support and Resistance Levels?

Support and Resistance represent key junctures where the forces of supply and demand meet. In the financial markets, prices are driven by excessive supply (down) and demand (up). Supply is synonymous with bearish, bears and selling. Demand is synonymous with bullish, bulls and buying. 

As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways as bulls and bears slug it out for control.

Trend Lines
In their most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (valleys). In a downtrend, the trend line is drawn along the top of easily identifiable resistance areas (peaks).

There are three types of trends:
  1. Uptrend (higher lows)
  2. Downtrend (lower highs)
  3. Sideways trends (ranging)
To create an up (ascending) channel, simply draw a parallel line at the same angle as an uptrend line and then move that line to position where it touches the most recent peak.
To create a down (descending) channel, simple draw a parallel line at the same angle as the downtrend line and then move that line to a position where it touches the most recent valley.
  1. Ascending channel (higher highs and higher lows)
  2. Descending channel (lower highers and lower lows)
  3. Horizontal channel (ranging)
What is Support? 
A price level on a chart where historically the trade has had difficulty falling below. The price level acts as a floor and prevents the price of the trade from falling any further.

A level of Support is always found BELOW prices.

There are two ways the trade will test this level of support:

  1. Either the trade will fall to this level and then "bounce" off of it and begin to rise again or...
  2. The trade will fall to this level, break through it, and continue dropping until it finds another level of support, a resting spot so to speak.
Below is an example of how support works. The trade found support around $40. It bounced around $40 for some time and then when it finally broke the $40 threshold, it continued dropping until it found its next level of support around $29.

The more times a trade falls to the level of support and bounces off it, the more significant (stronger) the price level becomes.

What is Resistance? 
The price level at which selling is thought to be strong enough to prevent the price from rising further.
The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. 

Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.

Two methods in trading support and resistance levels 

The bounce we want to tilt the odds in our favor and find some sort of confirmation that the support or resistance will hold. Instead of simply buying or selling right off the bat, wait for it to bounce first before entering. By doing this, you avoid those moments where price moves so fast that it slices through support and resistance levels like a knife slicing through warm butter.

The break there is the aggressive way and there is the conservative way. In the aggressive way, you simply buy or sell whenever the price passes through a support or resistance zone with ease. In the conservative way, you wait for price to make a "pullback" to the broken support or resistance level and enter after price bounces.

In conclusion, you must study how a trade behaves at key support and resistance levels and take note of market trend. This is a good time to look for or take the opposite side of the primary trend. Remember, climactic volume eats up a large amount of buyers and sellers and tends to produce sharp snap backs in either direction as buyers have put in major support and sellers will have put in major resistance going forward.

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