How To understand support & resistance concept?

Updated: Apr 4, 2020

All types of markets are driven by two major forces – buyers and sellers. Buyers create the demand for a product and sellers on the other side provide the necessary supply to meet buyers’ requests. This is the cornerstone of any economy – the supply & demand forces that cause price fluctuations. It is self-evident that:

  • When there is too much demand and interest for a product, logically the price goes up because sellers could bargain at a higher price being sure someone else will still buy their product.

  • Conversely, there are dry periods in any markets, either caused by the cyclical nature of the product or exogenous factors. During these times, the demand and interest for purchase slows down causing sellers to lower their price.

 
 

The supply and demand (S&D) forces are applicable in all financial assets, however, the variables influencing the S&D may differ across asset classes.


The essence is that buyers create demand when things are cheap and hence establish a support area (floor) while sellers provide the necessary supply and are always present when things become expensive; thus, providing a resistance (ceiling) to price action and this way prevent the price from going higher.


Consequently, trends and patterns form and price moves up and down. Even though everything boils down to spotting strong support and resistance levels, things are not that simple when it comes to highly volatile financial markets when sentiment changes frequently. It is paramount for a trader to also know how to react when a support or resistance is broken.


In this first article on support and resistance, we are not going to touch everything in detail since it is important for you to be able to understand the concept. Let's review a few examples, shall we?


APPL Stock - Daily Chart

Apple stock support and resistance.

S&P 500 E-Mini Futures - 4H Chart

E-Mini support and resistance

GBPJPY - Daily Chart

Market structure is simply the support and resistance area on a given chart. As a rule of thumb, we always look to the left to spot previous reversals and consolidation periods which establish support and resistance. Usually, we want to work with the most recent market structure and once we identify the zone, we then trade upon it.


Another important guideline is that, in most of the times, you should look to buy at support and sell at resistance. A few powerful techniques to identify meaningful support and resistance levels are (we will cover them in the other articles):

  1. Horizontal lines and diagonal lines – the above charts contain examples of horizontal s&r levels;

  2. Fibonacci tools – retracements and extensions;

  3. Moving Averages – trend based indicator;

  4. Previous highs, closes, lows and openings.

Another important point to remember and keep in mind is that when a support or resistance is breached then market will try to explore new territories and therefore that old support and resistance will become an important level for the future. Let us see an example:


S&P 500 E-Mini Futures - 4H Chart

The above chart shows what happens when a previous structure gets broken. Respective numbers show us important support and resistance levels in the market. We can clearly see what happens when resistance area "3" and "5" was broken - the uptrend resumed its course.


Let us focus on the support area "10" from which the market rallied, eventually for the last time during that period. When we reversed back from the highs, the market did not hold at support "10" but instead cut through like hot knife in butter. Previous pullbacks, such as "4", "6", "7", and "8" all established higher lows - a sign of buyers willing to step in the market.


Not the same psychology when market fell off the cliff from the high "11". Support "10" was broken instantly and wasn't even retested properly at "13", a usual behavior from market but not this time - something was fundamentally wrong - the CoronaVirus global outbreak. It was support area "4" and "6" that provided support for a strong bounce but even that zone was broken in the proceeding two trading sessions. The E-Mini S&P500 found demand once again at the 2018 lows, although we dipped a bit past that level too but managed to quickly close above.


To wrap it up, identifying key support and resistance area is only one part of the equation which we need to master quite well in order to move on to other advanced concepts. The following points are the main takeaways of this article:

Until the next time, safe trading!

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