Support and resistance

by Admin
Updated: July 15, 2020

The concepts of support and resistance can be used to predict a change in price direction

The concepts of support and resistance refer to the lower and upper bounds on the price of a traded investment. Understanding how & why prices can be expected to bounce back from these values provides a way of predicting the direction the price will go in a fluctuating market.

Support & resistance levels typically define a narrow range during a short period of consolidation. Long term support & resistance will usually define a broader range and, more importantly, limits that are stronger.

It is easy to see support and resistance retrospectively, but it’s more difficult to have complete confidence in them as trading progresses in real time.

Definitions

Resistance is the highest price seen or expected in a rising market before selling brings the price back down.

Support is the lowest price seen or expected in a falling market before buying pushes the price back up.

Rationalizations

Resistance: As a price approaches resistance, it means investors have been buying so the supply of buying investors may become diminished. At the same time, selling becomes more & more appealing (for realizing a return or anticipating a retracement) so investors usually begin to sell.

Support: As a price approaches support it may look more & more like a bargain so investors usually begin to buy.

Example

Following a breakout upwards at the beginning of 2018, the Euro and the US Dollar currency pair had been exhibiting fairly clear support & resistance behavior between mid January & mid April:

EURUSD price action November 2017 - July 10th 2018

The level of resistance is obvious. Support appeared to be around 1.22 but dropped slightly below this at the end of February before bouncing back. This false breakout was followed by a real one 7 weeks later that reverted to the longer term support level around 1.15.

Opportunities

When a market is moving up & down between between resistance and support levels that you believe in, you can buy as the price approaches support and sell as it approaches resistance as frequently as the price oscillates.

Buy at support, sell at resistance.

If for example the price of your investment fluctuates 2% during a month and ends the month at exactly the same price it started with, a long term investor would have seen no gain whereas a swing trader could have made up to 2% multiple times.

Risks

Breakouts happen. Sometimes the market does not revert, at least for a long time. This is great when you’re in and the direction is upwards but might force a loss when it goes down.

In the case of shares, a sensible lowest value of support might seem to be the fair value as calculated by DCF (Discounted Cash Flow) analysis. Very simply, if a company has x amount of cash and has issued y shares it must be worth at least x÷y per share. However, even this can be broken if it’s anticipated that the company will soon be separated from its cash for some reason.

False breakouts happen. This is when the prices pushes past the levels thought to be resistance or support but then revert.

Markets can be manipulated by major players. Whether the other players in the market are humans or algorithms, the majority are very sophisticated. They can all read the patterns and some of the humans may have additional insight. They can buy & sell against the market.

When the volume being traded is small compared to the variations in price, the costs of buying & selling can become a factor.

If you buy at 1.16 and then sell at 1.17, your return is (1.17-1.16)/1.16 ≈0.86% which means that, if your costs to buy & sell are $10 ($5 per trade), you need to trade more than $1,162 ($10/0.0086) simply to break even.

Over confidence: Analyzing markets retrospectively or simply being right a few times in succession can really make you believe you got this until something surprising happens.

More info

“Forex Support and Resistance” at babypips.com.

“Support and Resistance Basics” at investopedia.com.

“The Psychology Of Support And Resistance Zones” at investopedia.com.

“The 7 Types of Support and Resistance You Need to Know” from Nial Fuller at learntotradethemarket.com.

Internal links

Candlestick charts DCF analysis made simple AUD as an alternative to gold Recording your trades Go to Articles
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