Support and resistance zones can be considered a valuable tool of price action analysis for traders trying to be successful. They exist in the forex market because of four main reasons. It arises due to a significant number of traders using it to determine entry and stop loss levels. If there is an obvious support level, traders have a tendency to place their bids ahead of the level and place their stop loss orders below it. As the frequency of the currency bouncing off a given level increases, the interest that level attracts from buyers increases as well.
Another reason is large limit orders. These create pockets of liquidity that can almost stop the market movement. The third reason can be attributed to round number bias, which refers to our preferences for round numbers over non-round numbers. As a result, a large number of traders tend to leave their orders at round numbers and also attach more importance to breaks involving round numbers. As a result, highs and lows are often made on round numbers than non-round numbers.
Last but not the least, it exists because of option strikes and barriers. These create certain hedging needs around specific levels. For instance, if there is a large option in the market at any given level, the interest to buy or sell near that level is usually large, creating support and resistance as a result.
Somethings to keep in mind when using support and resistance zones
- The more times a particular support and resistance zone holds, the more likely the market is focused on it. In other words, almost everyone is looking at the same chart as you are, so will need to think out of the box, leaving your orders away from where the herd leaves orders.
- In the case, level support and resistance level breaks, the follow-through move will depend on how strongly the broken support or resistance has been holding.
- Another thing to note here is that if a trader initiates too far away from a support level, their position needs to be smaller. This is simply because they are risking more in terms of percent or pips before they hit the stop loss. Thus, the tighter a trader can fine-tune their entry point and stop-loss, the larger position they can have. This translates to increased profits if one makes the correct call and does not get stopped out.
- Always remember that when price passes through resistance, the resistance can also become the support. The more price tests these levels, the more chances that they are stronger.
Determining the zones
These zones can be effective on any time frame ranging from 15 minutes and upwards. However, it holds more weight when applied to higher timeframe charts. This is especially true for strategies that do not provide very frequent setups on higher frequency charts. The best way to draw support & resistance zones on a chart is to start from the monthly time frame, all the way down to the timeframe you are using. Drawing each formation in a different color can be helpful visually. This allows you to know which support or resistance area the formation is near and use it as a guide. Thus, the support and resistance lines become more significant as the timeframes are increased.
6 Rules To Draw Support And Resistance Lines
Rule #1
Always remember that support and resistance lines are not specific points but are zones. Thus, you should never expect prices to turn around instantly. Rather they will reverse in this general area. Standard zones like these can range up to 30 -40 pips in size. A rule of thumb is that the higher the time frame chart used, the greater the resistance of that area.
Rule #2
You should always use a thick solid line or something similar to point out where the support and resistance lines are, rather than mentally taking note of it. Adjust the positioning of the line in such a way that it visually suits the forex chart best. An example of this is shown in the chart below.
Rule #3
Always wait for confirmation of a price reversal before entering a trade. Always wait for a signal that the price is reversing before entering your position. Use indicators such as Relative Strength Index, Commodity Channel Index, or Moving Average Convergence Divergence to confirm a reversal, letting you know that the price is indeed retreating from the area of resistance.
Rule #4
The longer a support & resistance lines have been in existence, the stronger those lines usually are. This is especially useful when any currency pair approaches a certain area where it has not traded in a long time. These lines are stronger on longer time frames as well.
Rule #5
When trying to identify support and resistance areas, try to find ones that not only exhibit support or resistance individually but also can act as both a resistance and a support zone individually.
Rule #6
Try to add your own rules and filter that you find useful. You can play around with different charts and time frames to check which is the most productive for you.
Advantages of using Support and Resistance in Forex
- When using support and resistance in strategies, the trades that go according to usually have a great risk to reward ratio.
- The setup is quite predictable as traders can easily predict the price behavior around these levels.
- Trade entries are enhanced a great deal by the use of price action trading, which involves the use of reversal candlesticks.
- Stop losses are tight and are placed at ideal locations behind the support & resistance levels. This decreases the chances of traders getting stopped out prematurely.
Conclusion
When these zones in trading, the above mentioned rules should be modified to fit your own trading style. Regardless of the trading strategy, having properly organized support & resistance lines along with pivot points on your chart can serve as a very useful guide for trading.