How to apply Support and Resistance in your trade
Support and Resistance levels are two words which you will come across commonly in Forex. These are mainly expressed in terms of values on the charts. Let’s try to understand it in simple way. Support level refers to the point below which the prices don’t fall and resistance level refers to points above which the price don’t rise. So the area where the price stops after going down and turns back to moving up is the support. Similarly the point at which price stops from going up and starts going down is the resistance. So support forms the floor and Resistance the ceiling.
Now since the Forex market keeps changing, you will see that support and resistance levels are continuously formed in the chart representing the currency price movement. As the market moves lower and then bounces back to higher it creates support levels and as the market moves higher and then it bounces back to lower it creates Resistance levels. Understanding where these levels are helps a trader to open or close trades.
How does this actually happen. The very simple reason is supply and demand. When there are more buyers for a currency, the prices go up from the support level. Hence we can equate Support to Demand. Or we can say support levels are created by demand.
Similarly when there are more sellers than the buyers or when there is more supply, prices go down and hence forming the resistance levels.
In the above diagram, you can see that at the second support point, it was initially the resistance level and now became the support level. This is called Role reversal. We will try to understand that through another diagram.
As you can see above, the resistance level becomes support level at a stage when prices increase above the resistance level at certain point of time and is called role reversal. So normally when the price change in such a way that there is a new range formed for the price of a particular currency, role reversal occurs.
Why do you think is Support and Resistance important? Because it can be used to help traders decide and identify potential profits. Thus, support and resistance form an important part of trends. By looking at a trend trader will get to know if when the price of a currency reaches the support and resistance levels and when is the right time for him to take a position in the market. They are hence good tools for technical analysis.
At this point of time, let’s get introduced to the term trend line. In simple terms in a chart when you connect tops or bottom points, you get to see a trend. And the line which connects those points is called the trend line. A trend line thus shows the direction of price movement in addition to the support and resistance levels of the price. This tool is used by technical analysts to identify the trend and the entry and exit points for their trade.
Three kinds of trends which we should know:
- Uptrend: A trend line is drawn along the bottom of the support points.
- Downtrend: A trend line is drawn above the resistance points.
- Sideways trends: A trend line which connects peaks and bottom points when the market is flat, which means prices follow a constant pace and are neither rising nor falling.
Trend lines can be used in conjunction with other tools during technical analysis. The more points a trend line connects the better is the trend. Also keep in mind that, a break in a trend line means it is no longer a trend and hence becomes worthless.
When we draw a line parallel to the trend line we get a channel. A channel indicates potential areas of support and resistance and hence is used during technical analysis. Three types of channels:
- Ascending Channel: A line drawn parallel to the uptrend line forms the ascending channel.
- Descending Channel: A line drawn parallel to the downtrend forms the descending channel.
- Horizontal Channel: Line drawn parallel to the sideways trend creates a horizontal channel.
Generally, the top line in the channel is considered the means of identifying the selling positions and bottom line in the channel identifies the buying position.
Now, let’s try to understand how we trade support and resistance. Once you understand the basics, it’s also important to know how you can apply this knowledge while trading.
- Trader taking a long position can place the stop loss below the Support
Support and Resistance can help traders to mitigate the risk. For example, if a trader wants to take a long position (in other words, he wants to buy), he should be looking at the support level (low price). Hence it really makes sense for him to place the stop loss just below the support. Oops a new term – STOP LOSS. A stop loss order is an order to sell the currency if its price falls below a particular price. Thus a stop loss order is designed to limit the trader’s loss. Ok getting back to our scenario, once the price drops below support, the stop loss can prevent him from getting into a large amount of loss.
- Trader taking a short position can place the stop loss above the Resistance
Consider the scenario when the trader wishes to take a short position. Definitely by now you should be knowing that he should be looking at the Resistance or peak price movement. The trader should place his stop loss order just above the Resistance so that if the price rises above the Resistance point, the short position can be closed by the stop loss order and thus minimizing the amount of loss.
We know that support and resistance can break. A resistance line will be called broken, when the price goes above it. Similarly a support line will be known as broken if the price goes below it. As a trader it is required that you know how you handle a break in the support and resistance levels. Trader has to first locate the exact the support and resistance line or the range in which he wishes to take a position, wait for the price to go above or below them and then take the required position, i.e. buy and sell after resistance and support breakout respectively.
Locating the support and resistance levels is an important task done by traders as part of technical analysis (A separate topic by itself). The key is to realize that it’s not any rocket science. It is a skill which you will definitely improve through time and experience.