Price Action – Support and Resistance
If you base your trading decisions on technical analysis, your types of your trades will usually fall into one of the two categories – rebound trades or breakout trades. That’s it, just two! There is no rocket science in trading regarding the technical setups. Here we’ll focus on understanding the “rebounds”, how to identify support and resistance areas, and trading tactics for rebound trades.
Understanding the congestion of orders
“Congestion” of orders sounds a bit sophisticated, doesn’t it? But it is really quite simple. Congestion is the narrow range of prices, where there is a large number of potential buyers or sellers, compared to the rest of the nearby prices. It is also an area where we see a change in market sentiment and a change in the direction of price.
In the illustration below, you can see the potential congestion of sellers around the prices of 5560-5600.
Similarly, below, you can see the congestion of buyers around the prices of 5120-5200.
Often these “areas of interest” come up, as the result of only a few market participants, that have disproportionately large orders. Look at the illustration below.
Later on, more participants with different order sizes notice what ‘big guys’ are doing. Other participants join that congestion by trying to get their orders filled at the prices in “front of” the big guys, in other words, at somehow worse prices, but not too far from the big guys. Look how this action uncovers down below.
Eventually, as the result of those collective actions, you can see on the chart that the price sometimes consistently stops near the specific price areas and reverses.
What are Support and Resistance?
Support is the price area on a chart where, after a period of decline, buyers start buying so that the price stabilises (at least in the short term). The price appears to “bounce off” this price area and starts to move higher.
The buyers are “supporting” the market at these prices. It is the area where the buyers feel that the market is undervalued and are prepared to buy in expectation of a price increase.
It is important to note that we consider support to be a price range, not a specific price.
We can consider support to be a price area with a congestion of buyers. In the chart below, you can see the market declining until 6600-6620, and then reversing and heading up in the opposite direction. It is the area in which buyers are prepared to pay a higher price to enter the market, thus stopping the decline in price and pushing it back up. Therefore, in this example, the 6600-6620 price zone is a support area.
Resistance is the price area on a chart where, after a period of increase, sellers start selling so that the price stops rising and stabilises (at least in the short term). The price appears to “bounce off” this price area and starts to move down.
The buyers are “resisting” any further increase in the price at this level. It is the area where the buyers are not prepared to pay any higher to enter a position. Holders in the market are prepared to take profits (i.e. become sellers).
The Resistance is the congestion of sellers that flock around a particular price level or area. In the illustration below, the market is pushing up to 6200 and falling back afterwards. The Resistance, in this example, is around 6200.
How to use Support and Resistance in your trading?
The Support or the Resistance initially forms when a trend is unable to continue moving in the same direction. It happens when the market is unable to make a new high and move reasonably higher (or low in case of a downtrend). This forms an area of consolidation or an overall sideways movement in price.
The more times the market tests the resistance level and the longer the timeframe over which the level holds, the stronger and more significant the resistance becomes. It’s because the number of sellers who have closed their positions at this level is greater, so the number of the buyers, who took another side of their trades is greater too. The more “wrong” buyers are involved, the more likely they’d become sellers if the resistance holds.
We advise that you trade with the momentum of the market when it is moving in a trend. Identifying support and resistance zones will enable you to identify when the market is trading in a range, or consolidation. This will then enable you to identify when the support of resistance is broken, so you can look for a trading opportunity as the market moves into a trend. These trades have a higher probability of success and bigger risk reward ratio that trading within a range.
The breakout of the Resistance or Support occurs when the price manages to get through the price area and stay there, or to keep moving in the same direction (red area). If it happens, the Resistance area will often become a new support zone for a new uptrend. The same principle applies vice-versa for support.
If the price of an instrument rises above the resistance level, this is a bullish signal for the instrument. We use the term “bullish” to describe a market, where the prices are most likely to rise. This breakout above resistance is often an indication of a change in the market from consolidation to a new trend. However, it is important to look for a valid trading setup base on the price action to confirm this change.
Look at the example of the breakout below. You can see the resistance level was tested three times before the breakout (red zone). You can also see the price action making higher lows in the lead up to the breakout, which is in indication that the breakout may occur. You can also see subsequent to the breakout, that the resistance zone now becomes a support zone as the price seems to now bounce off this area.
Subsequent to the breakout, we want to confirm a strong trading opportunity with price action. In the example below, you can see that the price did breakout of the range above the resistance zone, but has failed to achieve a higher high on the pull back, so is not yet presenting a strong trading opportunity.
Now, let’s talk about the entry conditions. In the chart below we can see the uptrend that has stalled as it started testing the resistance several times. The recent lows of the uptrend formed the support.
To increase the odds of the successful breakout, we want to see the price action that serves as an evidence that the prior uptrend is reversing. In the example below the evidence is two lower highs that appear before the breakout. This is providing us with an indication that there may be a breakdown below the support area.
You can see in the example above, when the price breaks below the support, the buyers that entered the markets forming the Lower high 1 and 2 now are covering their positions, hence accelerating the move down. We can place a short-sell trade once the price moved below the support and the price action provides us with a confirmed trading entry. Our entry point is where we see a shallow retracement, and then the price creates a new lower low. This confirms the market has moved into a downtrend and our trade entry has a higher probability of success with a continued downward move.
Support and Resistance form as the result of the congestion of orders. It is important to be able to recognize support and resistance zones so that you can correctly assess the state of the market. Higher probability trading opportunities come from trading with the momentum of the market and with the trend. We can anticipate a breakout from a consolidation or trading range by looking for lower highs (down move) or higher lows (up move) within the trading range. We place a trade once the market makes a breakout above resistance or below support and we see a high probability trading setup such as a retracement.