How to Trade Support & Resistance Levels
Analyzing assets in the financial markets can be done in several ways — from using charting tools to dissecting news updates, different traders use different means to achieve the same goal — consistent profitability. Technical analysts use a lot of concepts to determine the future price of stocks in the market and once you have heard of trends, the next important concept in technical analysis is support and resistance.
What exactly is Support & Resistance?
Support and Resistance remains one of the most popular ways of trading the financial markets today. It is a concept in technical analysis that operates on the principle that the price of a stock tends to stop and move in the opposite direction when it hits certain pre-determined price points. An area of support is where the price of an asset tends to stop falling while an area of resistance is where the price tends to stop rising.
In the simplest of terms, support and resistance levels are like the ends of an Olympic swimming pool. Just as the ends of the pool tell swimmers when it is time to turn around and start swimming in the opposite direction, support and resistance levels tell you if the price of a stock or CFD is likely to stop, to turn around, and to start moving in the opposite direction in the future. Knowing where a stock or CFD may stop and turn around helps you to enter and exit your investments at the most profitable times.
The diagram (I) below gives a better understanding of this concept:
Looking at the diagram above, ‘resistance levels’ direct price to the lower end while ‘support levels’ direct price to the upside.
Smart traders however will require more information about support and resistance beyond those simple definitions before they make trading decisions based on those areas in a chart.
To use support and resistance effectively, you first need to understand how asset prices typically move, so you can then interpret support and resistance from that framework. You also need to be aware that there are different types of support and resistance, such as minor and major. Minor levels are expected to be broken, while major levels are more likely to hold and cause the price to move in the other direction.
Two ways to trade support and resistance levels
1. The Rebound.
When using Support and Resistance (SnR) levels to find high profitable trades, we would generally want the odds in our favor before entering the markets. This in combination with finding some sort of confirmation that the support or resistance will hold is key to profitability using this strategy. After the market condition has been identified, traders can then move on to the next step of placing the trade.
For example, instead of simply buying/selling right off the SnR levels, the idea is to wait for it to bounce off support/resistance before entering a trade. (Fig. 2)
By doing this, you’ll tend to avoid those moments where price moves fast and break through the support and resistance levels.
2. The Safe Haven
This way of placing trades involves using the Support and Resistance level to place a trade after the break and carry out a retest of the previous SnR level. The figure below does a good job in explaining this:
Note: In the financial market, the above will not always happen. Make sure to use your stop loss as a protective measure against possible reversals(risk management).
Key Points To Consider
When identifying support and resistance, look for zones versus precise prices levels. The number of inflection points also matters; the more there are the more important the area in question is. Seek out areas of confluence between more than one angle of support and resistance. If support is broken then it potentially becomes a new area of resistance and vice versa.
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