What is Support & Resistance?
As I keep on saying that everything is demand & supply, the price of each asset (including but not limited to stocks, bonds, commodities, etc.) is determined by the demand and supply forces.
Buyers push the prices higher and may be referred to as bulls and on the other hand Sellers push the prices lower and hence may be referred to as bears.
Supports & Resistances are the levels on the price chart where demand & supply is almost equal and hence the price struggles to move in one direction.
At higher prices, the supply increases with the limited number of buyers, and therefore the price struggles to move up further, and hence this price level act as a resistance. On the other hand, when the prices go down the demand increases with limited supply and therefore the price struggles to go further down, and hence this price level act as a support.
Event zones VS Support & Resistance?
Support & Resistance is the exact level on the price chart, on the other hand, Event Zone is a crucial range on the chart where we can observe an explosive move.
Event zones are more significant as there can’t be any exact level on the chart from where the price of the asset will revert every time, rather consider it as a crucial area and wait for any important price action signal (e.g.: – pin bar, candlestick patterns such as the hammer, inverted hammer, morning star, evening star, shooting start, etc.) to be formed in that zone as any such signal formed in this zone has a very high relevance and one can enter the trade based upon it.
Why market always reacts after hitting these levels & Important Principles of S&R?
The market has an amazing memory and it keeps in mind the crucial levels on the charts and whenever the price visits those levels it reverses or at least pauses for a while before continuing the original trend.
There is no rocket science in it, this happens because the number of traders expects the price to turn at these levels and they are ready to buy or sell at them.
The longer the price stays at a particular support or resistance level, the more significant the levels become. This is because the levels are observed by most of the traders and they will base their trading decisions on these levels.
We may also observe high volume at these levels as traders remember these levels and close or enter the positions once it is reached. The more the volume the stronger is the support or resistance.
Another important principle to note is that a resistance once broken will turn into support and vice versa. Breaking of resistance indicates a win for the bulls i.e. the demand is more than the supply and when again the prices fall to this level the demand arises thus shooting up the prices again. The same applies for support.
Support & Resistance is only a horizontal line on the price chart?
People often assume that fixed horizontal lines are the only supports & resistances on the price chart, but that is not true. There are several other forms as well such as Moving Averages & Trendlines. I will explain how they also act as support & resistance in brief.
These are dynamic supports & resistances; we call them dynamic as they keep on changing continuously depending upon the recent price action, unlike the fixed horizontal lines.
Refer to the daily chart of Info Edge below, I have plotted 21 EMA (Exponential Moving Average) on it. You will observe how 21 EMA has acted as support & resistance on various occasions.
Also, many traders plot two moving averages (e.g. 21 EMA & 55 EMA) and treat them as event zones and wait for an important price action signal to form in these zones just like a horizontal event zone.
A trend line is a straight line that connects two or more price points and extends into the future to act as support & resistance.
Refer to the daily chart of Info Edge below, I have drawn a trend line and see how this trendline has acted as a support on several occasions.
The break of the trendlines provides a signal that the buyers (in case of an uptrend) and sellers (in case of a downtrend) have lost grip in the market and we may observe a trend reversal.
Although there are several points that are to be kept in mind while identifying a valid trendline (which I will cover in my coming articles).
How to mark horizontal support & resistance on the charts?
First, mark longer-term key levels on the chart and then plot the short-term levels. For example, for my positional trading which involves holding a period of 15-30 days, I first refer to the weekly time frames then accordingly mark the crucial supports & resistances via horizontal lines. Then I switch to daily charts and then mark the levels which are relevant for a shorter period.
Try this yourself and you will find that most of the time the levels marked using weekly charts will be stay relevant even for the daily price bars.
Also, most people assume that support & resistance should exactly touch the bar highs or lows, but that is not correct. It is more important that the number of tails crossing the support/resistance line rather few highs/lows of the bars touching the levels. It is because this provides you with the average turning point in the market which is more relevant.
Refer to the daily chart of Asian Paints below, I have marked key long term level using a weekly time frame (represented by black horizontal lines) and then short term level using daily time frame (represented by grey horizontal line).
The above picture is of the daily time frame and you will observe that black horizontal lines marked using a weekly time frame are being respected by a number of daily price bars. Amazing, right?
Identifying the correct support & resistance levels requires practice and one should practice drawing it before taking actual trades based upon them.
Can we trade only on the basis of support & resistance (Break out or Range Trading)?
One can definitely develop a trading strategy based only on support and resistance, for example in case of range trading one can blindly buy or sell in the range, another side of the range will be the target, and stop-loss will be placed little far from these levels.
Also, these supports & resistances do not always hold and a breakout might actually occur. Once a support/resistance is broken another level is established which acts as a new support/resistance. Most of the traders try to predict the breakout and accordingly develop a price action trading strategy.
Support & Resistance also helps us to determine the risk-reward of our trades and we can place our stop loss as well as the profit targets based upon them.
Overall Support & resistance is a crucial part of Price Action Trading and one must learn to identify them in order to be a successful Price Action Trader.
By CA Saksham Agarwal; connect on Linkedin