Support and Resistance Price Levels
Resistance Becomes Support
Support and Resistance
In the stock and currency markets one of the easiest theories to understand is the notion of support and resistance levels. Economic theory tells us that when there is an over demand for a product or an asset, a large number of buyers have the upper hand in the market and therefore a price support level is formed, at the level at which the price has difficulty in dropping through. Where there are a large number of sellers who control the market there is an oversupply of the asset and a price resistance level is formed at which the price has difficulty in rising above it. These levels where the battle between supply and demand is strongest indicates that supply and demand are not balanced and the high volumes of trading at this level only goes to make these levels almost impenetrable.
To determine where these support and resistance levels lay is achieved through the use of technical analysis indicators. There are many such indicators that can be used however there is a few which stand out in popularity with both stock and currency traders.
What have you traded?
Have you ever traded foreign exchange or stocks?
If you look at a daily, weekly or monthly currency or stock price chart you will notice that there is a definite long term trend, Notice in the daily USD/JPY price chart 1 that the uptrend is more than three months duration (September 2012 to January 2013), however, in the hourly USD/JPY price chart 2 (Dec 2012), within this long term trend there are many short term trends. These trends are retracements or reversals from what is generally called a price top (upward trend) or a price bottom (downward trend).
Most traders have used Fibonacci Retracement levels at some point in their trading lives and indeed for many traders this technical indicator is their most popular principle indicator. I say principle because no trader should ever rely on one particular indicator. The successful traders have a prime indicator and use a second or third indicator to confirm the trading signal they have identified in the primary indicator.
The Fibonacci Retracement levels are 23.6%, 38.2%, 50%, 61.8%, 75% and 100%, with the most significant levels being the 38.2% and the 50% levels. These levels are support or resistance levels depending on whether the trend is downwards or whether the trend is upwards.
Support and Resistance Levels
Fibonacci in Music
What is a Retracement?
A retracement is where a price will reverse its current trend and move in the opposite direction until it has retraced itself to a known support or resistance level. So if a price was trending up it would hit a resistance level and reverse itself and retrace down to a support level and either bounce off that support level towards the original resistance level or fall through the support level down to the next support level.
If the price is down trending then the opposite happens. The price first hits a bottom support level and then retraces up to a known resistance level and again either bounces off it down to the original support level or rise through the resistance level to the next resistance level.
Chart 3 shows the EUR/USD price as it bounces off support or resistance levels. Notice how the 23.6% retracement level acts as a strong support level, the 38.2% and the 50% a strong resistance level. Because thousands of traders use Fibonacci Retracement the support and resistance levels almost become self-fulfilling prophecies as once these levels are hit thousands of traders’ trade in the same direction, which direction is dependent on whether the price hits a support or resistance level.
The 10 period moving average is another technical analysis tool traders use to determine support and resistance levels. One chart 3 is drawn the 10 day moving average line. Look how it acts both as a support level as the price retraces upwards and a resistance level as the price retraces downwards.
Many traders use Pivot Points to identify support and resistance levels. Unlike Fibonacci Retracement and Moving Averages, Pivot Points are used as short term support and resistance technical indicators. There are plenty of free pivot point calculators on the internet so I won’t go into the details of the formula. Chart 4 is the same EUR/USD price chart we have been using but instead of showing a daily time period it is now showing a 60 minute time period. The red lines show support and resistance levels derived from Pivot Point calculations. Notice how the 60 minute time period prices respect them as support or resistance levels.
Traders particularly day traders use prices ending whole numbers to spot support and resistance levels. Price that finish in 0 or 00 are seen by day traders to be major support or resistance levels. Notice how on Chart 5 which is our EUR/USD daily price chart again, how the red lines which have been drawn where prices have ended in ‘00’ or ‘0’ correlate with the Fibonacci Retracement levels. They in fact confirm that those levels represent strong support or resistance levels. It is these confirmations that a trader looks for as they are in fact powerful entry or exit signals.