Patterns are a trader's best friend.
In the previous lessons, we discussed identifying these patterns with trend lines and channels.
In this lesson, we'll discuss how to use that knowledge to make better trading decisions.
Not all support and resistance levels are created equal. This is important when identifying levels and if they are significant enough to base a trade on.
But before we get into that, let's quickly review support and resistance.
A support level occurs when there are more traders who want to buy a currency than those who want to sell it. This causes the decline in prices to stop or pause.
Think of the support level as a "floor price" for currencies that are moving down.
Resistance levels happen when sellers overpower buying interest. As a result, prices peak or pause in a price rally.
In contrast, consider resistance as the "ceiling" in a price advance.
Okay now we can discuss minor and major S/R levels!
Minor support and resistance levels form within the major levels. These are usually trendlines during short-term trends, and they are usually profitable for short-term traders (scalpers or swing traders).
Identifying minor S/R levels can give you useful insight. For example, if a price drops below the minor support level, we can concur that the price will continue to decrease. But if the price bounces above the previous low, we get a higher low, indicating a possible trend change.
A major support and resistance areas are price levels that cause a trend reversal. These are the levels at which the price constantly bounces back and forth. The more the price bounces off these levels, the more significant they are.
Major S/R levels can indicate where a price point will struggle to break through the previous high or bounce back to a downtrend.
Some levels may be stronger or weaker than others. However, their strength may be difficult to pinpoint accurately.
The best way to identify the relative strength of an S/R level is to look at its time and price significance:
These three factors can help you identify how strong S/R levels are.
Simply because support and resistance levels are made to be broken, forex traders spend time testing the support or resistance levels of a currency pair. This is important in forex trading because it defines longer-term trends.
Traders may test and break short-term support or resistance, which can be as short as 5-minute trend lines or hourly highs/lows. This serves as a guide to the future direction of prices.
Meanwhile, traders can also test long-term levels, such as daily or weekly highs/lows, to guide their longer-term trading.
It is important to test the strength of support and resistance levels because it is an important indication of the currency pair's strength.
Great! Now we can discuss trading techniques based on support and resistance levels!
The basic trading method for using support and resistance is to buy close to support in uptrends or to short near resistance in downtrends.
This is significantly useful for short-term traders but can help isolate long-term trends.
Buying near support or selling near resistance can lead to profitability, but remember! There is no assurance that the S/R levels will hold. This is why testing the S/R levels is important in forex trading.
Here we outline some of the basic methods in trading based on S/R levels.
The Bounce method means trading S/R levels right after a "bounce" or a change in trend.
Some traders use this method to "challenge" or re-test the existing S/R levels. This way, traders can confirm whether the support and resistance levels will hold or not.
Some traders set orders directly on the major support and resistance levels. This might work sometimes; however, it assumes that S/R levels are consistent.
Trading right before or right after a "bounce" can help you when prices move too fast and break through their S/R levels!
If buying near support, wait for a consolidation in the support area.
If a price moves this way, the price is still moving within the support levels.
This method also applies to selling near resistance.
Support and resistance levels break. All the time.
What do you do when price points break past their S/R levels?
In some cases, you might make a profit if you let a breakout occur instead of trading near S/R levels. You can hold on to your security and wait for the old support to become new resistance or vice versa, and then you can apply the bounce method again.
As mentioned several times before, the forex market is extremely volatile. This means prices can move in unexpected ways.
For example, a price can peak above resistance but eventually return to prices within the minor S/R level.
When this happens, we call it a false breakout or “fakeout”.
False breakouts are excellent trading opportunities. If the trend is up, and the price is pulling back to support, let the price break BELOW support and buy when it starts to rally back above support.
On the other hand, if a trend is down and is pulling back to resistance, let the price break above resistance and then short-sell when the price starts to drop.
False breakouts are difficult to predict, but placing a stop-loss order can reduce your risk.
Challenge yourself further on CommuniTrade
Keep up to date with trading news, trends, and analysis on CommuniTrade. Ask questions, verify facts, start thought-provoking discussions with fellow traders.