Support and resistance are technical analysis concepts which form the foundation for many trading strategies and other technical analysis methods. These concepts are often misunderstood, leading people to take trades at inopportune times. Learn the basics of support and resistance, as well as advanced concepts such as strong support and resistance and false breakouts.
Support Level Basics
Support levels are points where the price had a hard time pushing down through in the past. In other words, a support level is a level where a price stops falling. Often support can be found at slightly different levels. For example, the price moves down to $90 in the morning, later in the day it goes down to $89.90 before moving higher. Then, near the end of the day the price touches $89.95 before moving back up to close at $91.
In this example, 3 support levels are created, but together they form a support area. Support areas are more significant than a single level because it shows the market tried several times to breakthrough that region, but couldn’t sustain it. In this case, the support area would be $89.90 to $90.00.
Figure 1 shows an example of a support area. Notice how the price moves to a similar area over and over again, and appears to bounce off it. This is support because it shows buyers are willing to step in (or sellers back off) at that price area and push the price back up.
Figure 1. Support Area on USDJPY Daily Chart
Resistance Level Basics
Resistance levels mark areas where the price couldn’t push higher. In other words, a resistance level is where a price stops rising. Resistance levels also form resistance areas. If a stock rises to $90 then declines, rises to $90.10 then declines, rises to $90.05 and declines, the trader knows $90 to $90.10 is providing resistance.
Figure 2. Resistance Area on AUDUSD Daily Chart
Trading Resistance and Support Areas
Resistance and support levels are dynamic, meaning the price may edge past the old support resistance level, only to reverse course shortly after. This new price is a new resistance or support level, but should be coupled with old support and resistance levels in the same region to create a support or resistance area.
Support and resistance can be used for both trading and analysis purposes. While support and resistance are important they are only important in the context of what is happening around these levels.
During an uptrend, traders may wish to buy near a support area. Since the trend is up the price has a bias to move higher, so buying near a support area may provide a good entry point. Some people erroneously assume that just because the price drops below a support level that they should go short. It all depends on context. During an uptrend, the price may drop below a support level but that doesn’t necessarily signal a short trade should be taken. It simply warns the price is making a deeper pullback. It is more favorable to take trades by buying near support during uptrends than to take short trades during an uptrend even if support breaks.
During a downtrend, prices have a bias to decline, so buying at support is not recommended. Rather, look to short sell near resistance during a downtrend. As long as the downtrend is in effect, favor short trades, even if the price edges above resistance.
Support and resistance aid in analysis. During an uptrend support and resistance rise. A failure to do so doesn’t mean the trend is over, but could indicate the trend is in trouble. In this case, traders should refrain from going long and shouldn’t go short until a downtrend is evident. The analysis is telling us “Something may be changing here” so we sit our hands and don’t take trades. Other times our analysis will tell us “Things align. Take the trade!” This is the relationship between analysis and trading. Our analysis tells us when it is ideal conditions for trading, and when it isn’t. If conditions aren’t ideal, don’t trade.
During a downtrend, support and resistance levels occur at lower and lower price areas. A failure to follow this patterns means the trend could be in trouble. When the trend is doubt, avoid trades at support and resistance levels until the trend direction (which gives our trades the bias we require) is more evident again.
Support and Resistance Breakouts & False Breakouts
Support or resistance breakouts occur when the price moves through a support or resistance level/area. For instance, if a stock has moved up to $100 repeatedly, but can’t break above that price, $100 is a resistance level. When the price finally moves above $100 it’s a breakout. When the price moves to a resistance or support level, but doesn’t break through, it’s called a test (the level was tested).
Figure 2 shows support and resistance areas, followed by a breakout. The price breaks strongly through support and continues to move lower, showing that support for the asset (at that support level) is no longer there.
If the price moves quickly back the other way through the support/resistance zone it just broke out of, it’s called a false breakout. If a stock is bumping up against resistance at $100, and then the stock moves above that level, that’s a breakout. If it falls back below $100 shortly after and proceeds lower, that’s a false breakout. The price failed to move in the breakout direction. See Effective and Simple Forex Strategies for a strategy to capitalize false breakouts.
False breakouts can be a powerful trade signal. For example, if the trend is up and the price pulls back and forms a triangle–or any price pattern where the price is bouncing off a support area repeatedly–before the price moves higher there is often a false breakout. Since the trend is up, we can watch for a false breakout to the downside, below support, followed by a sharp rally higher. We now have multiple pieces of evidence telling us to go long: the uptrend and a support area that while slightly breached until held (false breakout) and sent the price higher.
Here is an example. The stock below was in an overall uptrend, and then had a strong pullback where it found support near between $50 and $49. In Nov. 2017 I actually bought this stock near support, with a stop loss just below the support level. I was stopped out on that trade as the price dropped below support. Because the strong uptrend that preceded the pullback I was still expecting a move back to the upside. When the price dropped below the support area (stopping me out) but then quickly rallied back to the upside, I was comfortable buying again following the false breakout. The price rallied following the false breakout and more than made up for the small prior loss.
This goes to show that we can’t know what is going to happen. During uptrends, I will often buy near support. If a false breakout occurs I may get stopped out initially, but am comfortable re-entering after the false breakout if everything still looks good. A small loss means nothing if you make the money on the next trade. That is why profits should always be larger than losses.
Figure 3. False Breakout of Support During Uptrend
The same concepts apply to downtrends. The trend is down and the price pulls back to the upside bumping up a short-term resistance level. If the price breaks above the resistance level briefly, and then quickly starts moving lower again, that is often a good signal to get short. The trend is down, and the price tried to move higher but couldn’t.
Strength of Support and Resistance
The strength of support or resistance can also be determined by the strength of the price reaction off of it. Any price area that reverses a trend is strong support or resistance. When the price comes back to test this area we can expect that some support/resistance will be provided in the vicinity of the reversal point. This doesn’t mean the price will always stop at that level again, but the area should be given some respect by the trader.
Figure 4. Strong Resistance Created by a Reversal
Strong support and resistance area can provide massive reward-to-risk trades. The resistance area in figure 4, created at the far left of the chart, let us know to watch for short trades in that area the next time the price visited that area. When the price does revisit the area, watch for bearish signals to enter a short trade. In this case, the reward from the decline that followed was huge relative to the risk taken (stop loss order placed above recent high). When we are wrong, and the price ends up moving through the strong support/resistance level, the risk and loss are small. When we are right the reward and profit are large.
Diagonal Support and Resistance (Trendlines)
There is also diagonal support and resistance levels. The lines or areas of support and resistance are called trendlines. To create an uptrend trendline, connect the low points during an overall rise in price. To create a downtrend trendline, connect the high points during the overall decline in prices. Trendlines show where traders are stepping in to stop the price from rising or falling. The actual support/resistance levels associated with a trendline are always changing since the trendline is sloped.
Figure 3. AUD/USD Hourly Chart
Trading with trendlines is almost the same as the support and resistance concepts discussed above.
During an uptrend, a rising trendline signals potential buy areas when the price revisits the trendline. I wait for the price to near the trendline and then start to rising again before buying, in the case of an uptrend. In the case of a downtrend, I will look to short once the price rises to the trendline and then starts falling away from it again.
Trendlines, while useful, can also be a little tricky to interpret at times. We still need to watch for higher price highs and lows during an uptrend, and lower price highs and lows in a downtrend. The price may drop below a rising trendline but still be in an overall uptrend. Some people erroneously assume that just because the price drops below a trendline the uptrend is over. Based on the support and resistance discussion above, we know that an uptrend is only drawn into question if the price drops below an area where the price found support in the past. If using trendlines, watch price action as well.
Figure 5. False Reversal Signal From Trendline – Price Action Says Trend Is Still Up
During an uptrend, use a trendline if is providing a reasonable area to buy and the price is making higher highs and lows. If the trendline doesn’t seem to align the price and hasn’t been providing good trade areas, don’t use the trendline for trading purposes.
During a downtrend, use a trendline if it is isolating reasonable short trade areas while the price is making lower highs and lows. If the trendline doesn’t align with the falling prices and hasn’t been isolating good areas, don’t use the trendline for trade ideas.
Final Word Support and Resistance
Support and resistance occur on all time frames. These levels are seen on one-minute charts, which may only show a few hours of price action, and on weekly chart which shows years worth of data.
When dealing with support and resistance, note the difference between trading and analysis. Analysis helps us determine which trades to take, but just because we are analyzing all the time doesn’t mean we should be trading all the time.
I prefer to trade during trends. In uptrends, I like to buy near support, especially after a false breakout of support when the price starts rising again. During downtrends, I like to short at resistance, especially after a false breakout and price starts falling again.
Trendlines can also be used in trending markets, providing price areas to watch for trades. When using trendlines, remember that price action is the most important thing, and a trendline is just a tool. Rely on price action first and foremost, as it reveals when trendlines are useful and when they aren’t.
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By Cory Mitchell, CMT