Eleven years at school, two years at college, three years at university, and all I needed to do was learn how to draw a horizontal line — Tom Dante
It is true and very funny if you think about it. Because that is how support and resistance are important to price action trading. Here, I will explain about how to draw support and resistance lines and also it’s inner workings and how to tell when support and resistance will break. So, let us get to it.
Support: The horizontal area on your charts where potential buying pressure could come in and push the price higher.
Resistance: The horizontal area on your charts where selling pressure could come in and push the price lower.
In short, you can treat support and resistance as areas of value on your charts to help you buy low and sell high.
Now how do we draw support and resistance? Obviously as you guessed it, there are a gazillion ways of doing it as it is subjective. But, here I give you some guidelines that you can use while you draw it.
- Zoom your charts out so they show at least 300 candles.
- Draw the most obvious levels (if you need to second guess yourself, it probably isn’t worth drawing).
- Adjust the levels to get as many “touches” as possible
I hope this will give you some clarity on how to draw support and resistance lines and please do not clutter your chart with too many support and resistance lines. Also, it does not mean you need to restrict yourself with only 3 lines as shown in the above figure. You can draw 5 or 6 lines if they are obvious fits.
Concepts on support and resistance lines
THE MORE TIMES SUPPORT OR RESISTANCE ARE TESTED IN A SHORT PERIOD OF TIME, THE WEAKER THEY BECOME
Let me explain this in detail.
The market reverses at support because there’s buying pressure to push the price higher. This buying pressure could be from institutions, hedge funds, or banks that have orders to fill around certain price levels.
And when the price re-tests support, some of these orders get filled. So the more the price re-tests support, the more orders get filled. And when all the orders get filled, who’s left to buy? No one. This is when the market breaks down.
SUPPORT AND RESISTANCE ARE AREAS ON YOUR CHART
Why do I say that support and resistance are areas and not lines? As you can see in the above figures, I have put it as a area an not as a line. Though we can draw in the actual chart as lines, to make things easy and clear on chart, we should always consider support and resistance as areas and not as lines. Why you ask? I will explain.
It is because of 2 types of people – FOMOs and Cheapos. FOMOs(Fear Of Missing Out) want to buy the stock as soon as it reaches the support so if there is enough buying pressure at this point then price reversal can be seen right here and price will barely touch before rallying higher.
Cheapos are those traders who only want to buy the shares at the cheapest price. So, they look to buy at the lows of the support. If there are enough traders who behave in this manner, the price will reverse near the lows of support.
You have no idea which group of traders are dominant at any one time and whether what you’re seeing is due to the FOMOs or the cheapos. That’s why you want to treat support and resistance as an area on your charts and go in with the expectation that the market could reverse anywhere within the area.
WHEN THE PRICE BREAKS SUPPORT, IT COULD BECOME RESISTANCE
When the price breaks below support, that horizontal area could become future resistance. And when the price breaks above resistance, that horizontal area could become future support.
Why do you think this happens? I will explain.
Losing traders want to exit their trade at breakeven
Imagine you bought at support thinking the price would rally higher. The next thing you know, the price collapses and you’re in the red. So, you hope for a rebound to occur so you can exit your trade at breakeven (and there’s no win or loss on the trade). This behavior creates selling pressure at the previous support area. And if there’s enough selling pressure, the price could reverse at the previous support area, which now becomes resistance.
Traders who missed the breakout move
Sometimes the market breaks out so unexpectedly that you miss the move. And you regret your inaction, wishing you had paid more attention to the markets. So what do you do to “tame” that regret? You place a limit order at the breakout price point. If the market ever re-tests the level, you won’t let it get away this time round. For example, if the price breaks out of resistance and traders miss the move, they’ll place a buy limit order at the previous area of resistance (the breakout point). And if there’s enough buying pressure, the price could reverse at the previous resistance area that has now become support.
THERE ARE OTHER WAYS TO IDENTIFY AREAS OF VALUE (NOT JUST SUPPORT AND RESISTANCE)
You can also use tools like moving averages, trendlines, channels etc. to help you identify areas of value. For example, in a healthy trend, the price tends to respect the 50-period moving average and this acts as an area of value.
If you have any doubts or questions, Please let me know. ConversionConversion EmoticonEmoticon