Support and Resistance Trading: The Ultimate Guide

A stock price reaches a low level of support after some time, and a stock price reaches a high resistance level. Stock prices drop to levels that encourage traders to buy when support materializes.

Intro

The concept of trading level support and resistance is undoubtedly one of the most widely discussed attributes of technical analysis. As part of analyzing chart patterns, traders refer to these terms as price levels on charts that act as barriers, preventing an asset's price from being pushed in a specific direction. At first glance, the concept of identifying groups seems simple, but as you'll find out, support and resistance trading can take many forms, and the idea is much more difficult to master than you think.

When supply and demand meets, the points in time are called support and resistance levels. Technical analysts believe that support and resistance levels are vital to understanding market psychology, supply and demand. Prices are determined by the excess supply and demand in the financial markets. A bearish market is one with a lot of supply. Bulls and buying are synonymous with order. Prices rise when demand rises and falls when supply falls. 

Bulls and bear sluges it out for control when supply and demand are equal.

The supply and demand powers have created these levels of support and resistance are assumed to have moved once they are broken, in which case, new levels of support and resistance will likely arise. The support and resistance pillar is one of the most powerful in trading, and most strategies include some form of support/resistance analysis (S/R). Price has consistently approached and rebounded from key areas where support and resistance develop. 

The Psychology behind support and resistance

There is support when a downward trend pauses due to a demand concentration. When an uptrend pauses temporarily, resistance results because of a concentration of supply. Despite appearing arbitrary at first glance, these levels are determined by market sentiment and anchoring. The reason traders buy or sell can vary, but they are mostly motivated by the profit motive - either to make more money or to help ease the pain of losing money on a previous trade.

Consider that a stock has been fluctuating between two levels, a support level at the bottom and a resistance level at the top. As the price rises off a support level, this is what they would be thinking –

• They wish they had bought more so they could have made a more significant profit. Long-term traders were congratulated on being intelligent traders. They may believe that they will buy more if the price goes down to that level.

• As they believe they may have been wrong, the shorts hope that the price will fall again. Even if they do, they will be able to cover their positions and get out of the trade without losing so much.

• Hesitant undecided think they might have missed the boat by hesitating and even lost out on a profitable trade. If the price falls again, they make up their minds to buy shares so as not to miss out again.

In the example above, consider that a stock is trading between two levels: at the bottom is a support level, and at the top is a resistance level. The way they would think if a price rose off an important level of support is -

• Since they could have made more money if they had purchased more, they wish they had done so. It is possible that they will buy more if the price drops to that level again.

• Shorts are hoping for a price drop since they believe they may have made a mistake. In any case, at least they can exit without losing so much money by covering their position.

• Undecided might have missed a good opportunity by hesitating, thereby losing out on a lucrative deal. If the price drops again, the shareholder decides to buy more shares to avoid missing out a second time.

• Prices goes down the level of support, every group decides to buy. You can see where the trend is going, but it's not right to simplify the psychological complexity of trading. As all three market participants demand shares, the falling price will reverse according to supply and demand.

Overview of Support and Resistance 

What is support and resistance?

In economics, the level of support and resistance refers to the intersection of supply and demand. According to technical analysts, these support and resistance levels are important in determining market psychology and supply and demand. In the financial markets, the use of technical analysis techniques like support and resistance trading is common.The following are three points of interest to a trader that can be determined from a quick chart analysis:

• The direction of the market

• Entering the market at the right time

• Setting exit points based on profits or losses

Support

A support level is a zone on a chart where the price has dropped to but has struggled to break through. Above is the diagram that shows how the price drops down to the area of support and then suddenly 'bounces' back up again.

According to theory, a support price level is when demand (buying power) is high enough to prevent a further price decline. Buyers see a better deal as the price gets closer to support, and as a result, they are more likely to buy when it gets cheaper in the process. When sellers get a worse deal, they are less likely to sell. In that scenario, demand (buyers) would overcome supply (sellers), and the price would not fall below support levels.

Resistance

A resistance area is a line on a chart where the price has risen but has struggled to overcome. Above is a diagram showing how price rises to the resistance area and then "bounces" sharply from there.

A price level of resistance is where the supply (selling power) is strong enough to limit the price from rising further. Essentially, as the price gets closer to resistance and becomes more expensive in the process, sellers will be more inclined to sell, and buyers will be less inclined to buy. In that scenario, the supply (sellers) will overwhelm the demand (buyers), and the price will not rise above the resistance level.

What Are the Methods to Establish Support and Resistance

The support level is typically below the current price. Still, sometimes security can trade at or near support, while the resistance level is usually above the current price, but sometimes security can trade at or near resistance.

A precise support level is difficult to determine when doing technical analysis. Prices can also dip below support at times, as well as fluctuate. Due to this, some investors and traders mark support zones. As a result, sometimes, it does not seem logical to consider a resistance level broken simply because the price closed eight pips above the established resistance level. Therefore, some investors and traders create resistance levels.

Highs and Lows

Support can be determined by looking at the previous reaction lows, while resistance can be determined by the previous reaction highs. Stock prices continued to rise after each bounce-off support. Support levels can become resistance levels after they are broken. 

Support Equals Resistance

In the case of a price break below a support level, that support level can then become a resistance level. As the supply forces have overcome the demand forces, the support has broken. Therefore, if the price comes back to this level, supply will likely increase, and resistance will follow.

In the other direction, resistance can turn into support. The price rising above resistance signals the change in supply and demand. Breakouts above resistance show that demand has overpowered supply forces.

Trading Range

When it comes to determining whether support and resistance act as a turning point or as a continuation pattern, trading ranges can greatly be important. A trading range is a time period in which prices move within a relatively narrow band. A fairly balanced market is indicated by a trading range. As soon as the price breaks out of the trading range, either above or below, it indicates a winner has emerged. Breaks above or below the trend line are victories for the bulls (demand) and for the bears (supply). 

Support and Resistance Zones

In technical analysis, support and resistance zones are useful because it is not exact science. It's counter to the strategy mapped out by Lucent Technologies (LU), but it does happen from time to time. The intricacies of each security should be reflected in the analysis. Often, exact levels of support and resistance are best, but in other cases, zones are best. If the range is narrower, the level will be more precise. When the trading range is less than two months long, and price ranges are relatively tight, more precise levels of support and resistance are most suitable. Trading ranges that span several months and have a reasonably large price range are best identified using support and resistance zones. This is known as a general guide, and each trading range should be evaluated individually.

Best Support and Resistance Trading Strategies

To interpret support and resistance effectively, you must first understand how asset prices typically move, so you can then interpret support and resistance from that perspective. It is also important to know that there are different types of support and resistance, including minor and major/strong. The price is expected to break minor levels, but strong levels are more likely to hold and cause the price to move in the opposite direction.

• Top of Form

• Bottom of Form

In the following list are four ways to trade support and resistance:

Range Trading

As traders aims to buy at support and sell at resistance, range trading occurs in the space between support and resistance. The area between the two supports and resistances can be considered a room. Floor and ceiling represent support and resistance, respectively. A range often appears in sideways markets when no clear trend is apparent.

Trading ranges need to be identified; therefore, support and resistance levels must be identified. As shown in the chart below, the areas of support and resistance trading strategy can be identified:

Generally, traders tend to look for long positions when the market bounces off support and short positions when it bounces off resistance when the market is range-bound.

In view of this, traders should be careful when setting stops when long and when short, as the price has not always respected support and resistance boundaries.

A price breakout can either be a genuine or a false breakout, also called a "fakeout". When markets break out of range, it is vital to adopt sound risk management to limit downside risk.

Breakout Strategy 

Following a period of directional uncertainty, the price will usually break out and begin trending. Traders often seek a breakout below support or above resistance in order to take advantage of further increasing momentum in one direction. There is a possibility that this momentum will lead to a new trend.

However, top traders tend to wait for a pullback before taking a trade to avoid falling into the trap of false trading breakouts.

If the market moves down again after the pullback, traders should look for entry points.

Trendline Strategy

Trendlines serve as either support or resistance in the trendline strategy. In a downtrend, draw a line connecting two or more highs and two or more lows in an uptrend. When prices fall below a trendline, they will bounce back up and move in the direction of the trend. Therefore, traders should only look for opportunities in line with the trend for high probability trades.

Using Moving averages as Support and Resistance

Dynamic support and resistance can also be derived from moving averages. There are two popular moving averages: the 20 periods moving average and the 50 periods moving average, which can be further modified to 21 and 55 period moving averages by incorporating Fibonacci numbers. No rule prohibits traders from incorporating There is no right or wrong setting for the 100 and 200 MAs. It is mainly up to the trader to find a setting that suits them.

The chart below clearly shows the 55 MA initially tracking above the market as a resistance line. A bottom and reverse take place, and the 55 MA becomes the dynamic support level. With these trendlines, traders can determine which markets are likely to continue trending and susceptible to breakouts.

Support and Resistance Role Reversal

In technical analysis, it is a key concept that a support or resistance level reverses when it is broken. Whenever a level of support is broken, that level becomes a resistance level. If it rises above a resistance level, the price will typically move into support. Supply and demand shifted whenever a price breached a support or resistance level, making the breach level a source of support instead. 

In terms of support and resistance, one of the most interesting phenomena arises when the underlying asset price finally breaks out and exceeds the identified level. It is common to see a previous area of support change into a new resistance area when this occurs. The chart below shows that the dotted line represents the price that propped up price movement at points 1 and 2; however, once the price falls below the dotted line, it becomes resistant, as illustrated by points 3 and 4.

Price breaks above resistance when the price reverses this process. The figure below shows that points 1 and 2 start out as price barriers, but once the bulls can force the prices above the dotted line, it becomes a support zone.

Final Thoughts

Analysis of technical data is one of the methods of predicting future market or security prices. Fundamental analysis may be used in conjunction with technical analysis by some investors; they use fundamental analysis when determining what to purchase and technical analysis when determining when to purchase.

It is important to identify key support and resistance levels to perform a successful technical analysis. The knowledge that support and resistance trading levels exist and where they are can greatly enhance analysis and forecasting capabilities, even if they are difficult to establish. When security approaches a key support level, it can serve as an alert that higher buying pressure could be on the way, and a possible reversal may occur. As security approaches a resistance level, it may signify that selling pressure increased and a potential reversal was occurring. It indicates that the relationship between supply and demand has changed if a support or resistance level is broken. We are living in the midst of a bull market (demand) when a resistance breakout occurs, while the bears (supply) have won the battle when a support breakout occurs.