- 1 What Is a Support and Resistance Level?
- 2 How Do You Determine Support and Resistance Levels?
- 3 What is a Support and Resistance Level?
- 4 Common Mistakes When Marking Levels of Support and Resistance
Support and Resistance are the cornerstones of technical analysis and trading strategies. While every trader has their own personal trading style – some prefer naked charts, others rely on Moving Averages, RSI’s, Fibonacci Levels, Ichimoku Clouds or some other indicator – at the end of the day, it doesn’t really matter. Every trader on the planet is paying close attention to key levels of support and resistance.
While the concept of support and resistance is easy enough to understand – identifying and drawing these lines is a much more difficult skill to master. In this article, we take you through the importance of support and resistance zones, the steps to identifying them and the mistakes that are commonly made.
What Is a Support and Resistance Level?
Stock charts paint a picture of supply and demand. A chart will tell you where the buyers are, where the sellers are, and the areas where price finds support and resistance. These areas serve as valuable markers that are fundamental in identifying entry, exit, stop loss, profit taking levels, and risk to reward ratios.
Think of support as the ‘floor’ – the area where the stock price has difficulty falling below. This is where buyers are expected to step into a falling trend, causing the downward trend to pause as demand increases.
Think of resistance as the ‘ceiling’ – the area where the stock price has difficulty rising above. This is the area where sellers come into a rising trend, causing the upward trend to pause as supply increases.
If a stock is trending (either upside or downside), traders can connect the peaks to form a trendline that acts as resistance. A trendline that connects the troughs acts as support.
Once a stock reaches a support or resistance zone, it is likely to either:
- Bounce back into the trading range;
- Breakout or breakdown – Continue on in a trend until the stock reaches the next levels of support or resistance; or
- Fake-out/false breakout – Stock price momentarily pushes through a level only to reverse back into range.
Remember that support levels and resistance levels are not set in stone. They are bound to be broken sooner or later as stock price moves. However, it’s quite common to see that a previous area of support will become new areas of resistance (and vice versa) in the future.
Traders should also be wary of fake-outs as market makers are known to stop loss hunt. It is well known that many traders will set their stop-loss limits at or just below the level of support. By momentarily driving the price down past support, market makers can then purposely trigger these sell top orders, only for the price to quickly reverse back upward. To avoid being stopped out, traders should avoid setting your stop loss at the line of support. Use a wider stop loss about 10% from the level support – but only if it meets your risk profile.
Follow the Money – Breakouts and Breakdowns
By focusing on areas of support and resistance, you can see where the money is flowing.
A stock price that breakdowns and falls below long term support suggests that a significant amount of money is flowing out of that stock. This is a sign that the stock price will likely continue to fall. When a stock makes a new low, any traders left holding the bag will be waiting for a retracement to get out of that position. Thus drawing the stock to an even lower low.
Likewise, when a stock breaks out and reaches a new high, it is likely to move even higher as there is little resistance at that level. Few traders are left hanging on to sell as they likely would’ve already sold on the runup. However, there will no doubt be many traders waiting in line for any pullback to jump on the bandwagon. Thus drawing the stock to an even higher high.
How Do You Determine Support and Resistance Levels?
By now you will have understood the importance of accurately mapping out areas of support and resistance. But how do you determine these levels on a stock chart?
We go through the steps below. But unfortunately, while the steps sound easy enough – many traders struggle to find support and resistance zones in practice. If you are having difficulty, don’t be discouraged. Identifying levels of support and resistance is a skill that is built up over time through lots of practice and analysis.
What is a Support and Resistance Level?
Steps to Identifying Support and Resistance Levels
There are thousands of ways to identify a support level and resistance level on a chart. Some traders will use indicators (we discuss these below) but we honestly prefer to draw them ourselves. By observing price action you can learn to decipher what the market is showing you. Our method is simple yet effective and can be adapted to fit into any trading strategy.
Step 1 – Start With a Clean Chart.
Support and resistance is all about price action – nothing else. Remove distractions and simply focus on the stock price. Indicators have a tendency to cloud a trader’s judgment. This is especially true where a trader has multiple indicators on one chart, a trader can easily convince themselves they are seeing things that are not necessarily there. When it comes to drawing lines of support and resistance – keep it simple and start with a clean chart.
Step 2. Look at Weekly Highs and Lows.
Look at weekly timeframes to see where a stock has sold off or bounced. We start with the weekly chart so we can see the big picture of what’s happening with the stock in the market. Do you notice any price levels where the stock price has tried and failed multiple times to break? The more times a stock pulls back from a certain level, the stronger the resistance. The more times a stock bounces or holds a certain level, the stronger the support. Try to connect these price action zones with a horizontal line.
Step 3. Align Support and Resistance on Multiple Time Frames.
Start with a weekly timeframe then narrow it down to daily and hourly timeframes. Use different colors to signify different time frame levels. The more time frames you can align, the stronger your level of support/resistance.
Step 4. Simplify.
Remove any levels that are not close to the current stock price. They will only confuse you. If the stock price does dramatically jump, you can always redraw your lines of support and resistance. But in the meantime, keep your focus on levels that are just a few pips away from current stock price and pay even greater attention to levels that have shown strength (i.e. levels that have been tested three or more times and levels that have aligned on multiple time frames.)
Keep an eye on round numbers. For example: 100, 250, 1000, 1500, 2000 etc. Where you draw your lines is going to have some psychological implications. Round numbers have shown themselves time and time again to be important psychological support or resistance level that traders and the market at large respond to. Monitor round numbers and use them to your advantage when support and resistance trading.
Some traders prefer to use indicators to identify support and resistance zones. While we prefer to draw levels ourselves, indicators can be helpful where price action is moving quite quickly.
Moving averages plots the average stock price on a chart and is helpful in drowning out the noise from price outliers and volatility. There are two common moving averages – The Simple Moving Average (SMA) and the Exponential Moving Average (EMA). The difference being that EMA places greater significance on recent price observations which allows it to react faster to the latest changes in price data. The lines created by SMAs or EMAs can be used to provide levels of support or resistance. Where stock is moving in an upward trend, the moving average can be used to provide a line of support. In a downward trend, the moving average can be used to provide a line of resistance.
Fibonacci Retracement levels are horizontal lines based on the Fibonacci sequence that show where support and resistance are likely to occur. Fibonacci numbers are found throughout nature and traders have been found to react favorably to Fibonacci values in the stock market.
Traders use Fibonacci Retracement levels to connect two points on a chart, typically a high and low point. When a stock price approaches a level, there is an expectation that the stock will reverse and bounce off the level. The Fibonacci Retracement levels are 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
While many traders swear by Fibonacci Retracement, a common problem associated with using this indicator is that it provides little assurance or reasoning that price action will actually pause at or near Fibonacci levels except for trader psychology. Also, because there are many levels, it can also be argued that of course price will reverse near one of the levels anyway. If you do decide to use Fibonacci Retracement, don’t use it exclusively. Try to wait for confirmation by doing your own further analysis or using additional indicators before you enter or exit positions.
Pivot Points use the previous day’s price movements (low, high, and closing price) to predict seven levels of support and resistance. While this method is best for intraday traders, swing traders can use the previous week’s data to determine pivot points for the following week instead.
Pivot Points consist of a Central Price level (P) with three levels of Support below (S1, S2, S3) and three levels of Resistance above (R1, R2, R3). As with all indicators, don’t rely on Pivot Points alone. They are best used in conjunction with other indicators and of course your own technical analysis.
Which time frame is best for support and resistance levels?
For intraday traders, scalpers, and swing traders, we prefer our method of starting with a weekly chart and then narrowing down to daily and hourly charts. Unless you are a long-term buy and hold type of investor, there is really no need to use time frames greater than 6 months. While knowing where these long term levels of support and resistance can be helpful in giving a trader an overall picture of the stock – these long term levels are only really relevant if the current stock price is approaching one of those levels. If the current stock price is 100 pips away, don’t mark it. It will only be a distraction.
How to determine the significance of zones?
A support level and resistance levels can be characterized as having minor, major, and strong significance. Which measuring the strength of support and resistance zones, traders take into account the following:
Number of Touches – There is more of an expectation that traders will respect levels that have been tested on numerous occasions. The more times the level has been tested, the more significant it will be. Trendlines that are made by connecting five or more bottoms, will be more significant than trendlines that only connect to two.
Volume – The greater the volume of buying and selling at a support or resistance zone and the stronger the zone. High volume shows that many traders are respecting and using that level.
Time – Typically levels that have been retested over extended periods of time will often be more respected by traders. A trend line on a weekly chart that aligns with a trendline on an intraday chart will have strong significance.
Common Mistakes When Marking Levels of Support and Resistance
Marking to Precision
It is a mistake to view support and resistance as absolutely precise lines on a chart. Instead, imagine that you are drawing these levels with a thick crayon and not a fine liner pen.
These levels are areas or zones. They are not exact and nor should they be. Why? Because markets are dynamic. Price action is constantly moving and there are bound to be some noise or outliers. With levels being tested over and over again and market makers setting fake out traps, you’re rarely going to get textbook perfect levels.
Instead, be cautious and prudent with setting your stop losses and profit targets. Practice good trade management and monitor stock price when it approaches one of your levels. But give yourself a little bit of leeway.
Don’t get carried away and start over marking your charts. You need to maintain clarity in your analysis otherwise your judgment will be cloudy.
Only include levels that are going to influence your trading decisions. These levels will typically be limited to your trade setup – entry, exit, stop loss, and profit targets. Everything else is irrelevant. If you don’t have a good answer to the question: ‘Why did I put this line here?’ – then get rid of it. It needn’t be there. Your charts should be clear and logical so you don’t get lost in your own analysis.
We can’t stress the importance of Support and Resistance enough. These levels aren’t just lines on a chart. They are the most straightforward way to manage risk and are the foundations of any successful trading plan.
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