Welcome to Level 5!
If you made it this far, I think it is safe to say you are serious about becoming a forex trader. Now, after we have covered the basics, it’s time to get technical. When I mean technical, we are talking about learning how to draw lines on forex charts and use technical analysis indicators.
Support and resistance trading levels are one of the key trading tools used by technical analysts and are seen by traders as a very effective technical analysis technique. Obviously, you can use support and resistance when you analyze all financial markets – a stock price, a commodity price, whatever.
So, in the lesson, we’ll explain what support and resistance lines are and how you can use them in forex trading. By the end of this lesson, we promise you will know how to draw support and resistance levels on your trading platform and maybe find profitable forex trades (that’s up to you, my friend).
Okay, no more chit-chat, let’s get to it.
Support and resistance levels are valuable trading tools used by Forex traders that help them to identify possible entry points on Forex charts where prices may change directions. By studying these levels on a price chart, Forex traders can also obtain a better understanding of what is going on in the Forex market, and use these price levels to determine when to buy or sell foreign exchange currency pairs.
A picture, or in this case, a zigzag pattern, paints a thousand words so let’s take a look at what support and resistance levels mean in practice.
As you can see in the image above, the support indicator occurs when falling prices stop and move in the opposite direction, hence, beginning to rise. It is often viewed as a “floor” that is supporting or holding up prices. In other words, support levels indicate where there will be a surplus of buyers and signal an entry point for a long (buying) position.
Resistance is a price level where rising prices stop, change direction, and begin to fall. It is often viewed as a “ceiling” keeping prices from rising higher. Therefore, resistance levels indicate where there will be a surplus of sellers, and indicate an entry point for a sell (or short sell) position.
In their most basic sense, support levels denote that the price of a currency pair will not likely fall below this level, while resistance levels indicate the price of the currency pair will probably not exceed the resistance level. Traders tend to use support and resistance zones as a safe zone to buy an asset and change their strategy if the price drops below the support level or the price breaks above the resistance level.
Generally, by using the support and resistance indicator tool, Forex traders can more accurately predict whether a current trend will keep going or, alternatively, reverse. Armed with this technical analysis trading strategy, a trader can potentially find a price point to enter a position, or close a position, and place a stop or a limit order.
But at this point, we may be getting ahead of ourselves. We need to develop the foundation before we build the house, right? So first, let’s see how we can draw support and resistance levels on a trading chart.
Understanding the concept of support and resistance levels is the first step in knowing how to use support and resistance strategies in forex trading. But the big challenge is how to draw these lines, and more importantly, how to find support and resistance zones in a trading price chart. In most cases, it may take some time for you to identify support or resistance zones and know how to use these levels to find trade entry points.
With this in mind, it is also important to remember that support and resistance levels are not always exact numbers or round numbers price points. They are usually a zone covering a small trading range of prices so levels can be breached, or pierced, without necessarily being broken.
Throughout your forex trading journey, you will often come across a support or resistance level that appears broken, but soon after you’ll find out that the market was just testing it. If you’re using candlestick charts, these “price tests” of support and resistance levels are generally represented by the candlestick shadows that pop out of the support or resistance area.
Can you notice how the shadows of the candles tested the 1.4700 support level? At those times it seemed like the price broke the support level, however, this situation is known as a false break and is one of the reasons why you should wait until the first candlestick is completed in order to enter (or exit) a position. Looking back, we can see that the market was only testing that support price level.
That is one way of using the support and resistance indicator. Once you notice that the price of the asset rises from the support line, you can mark this level and identify it as a support price level. This technique is strongly confirmed by a third support price level and round numbers. The same, obviously, works for the other side – meaning identifying a resistance level.
All things considered, knowing where and how to draw support and resistance levels on a trading chart is the most important aspect of this technical analysis tool. As we mentioned, support and resistance areas are price levels where prices of the trading instrument move in the opposite direction and create a trading range. Consequently, the best way to find support and resistance lines in a chart is to identify at least two price levels where the price reversed at the support and resistance zones.
Unfortunately, there is no definite answer to that question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is not always the case.
Let’s look at the same example from above and see what happened when the price actually closed past the 1.4700 support level. In our example, the price had closed below the 1.4700 support level but it ended up rising back up above it. Tricky, right?
In the example above – if you had believed that this was a real breakout and sold this pair, you would end up losing money. Looking at the chart now, you can visually see and come to the conclusion that the support was not actually broken, and the three candlesticks below the support level are, in fact, false signals.
To help you filter out these false breakouts, the trick is to think of support and resistance more as “zones” rather than concrete numbers.
One way recommended by Forex experts that helps traders find these zones and to avoid the significant risk of false breakouts is to plot support and resistance on a line chart rather than using a candlestick chart. The reason is that line charts only show you the closing price while candlesticks add extreme high and low prices to the picture which can be distracting, and affect these key levels.
Nonetheless, if you insist on trading forex with candlestick charts, you should still use the rule of waiting until the candle is fully completed. Even more than that, wait for the second or third candle after the price tests the support or resistance level and only then make a trading decision to get in or out of a position.
The big question – how do you trade support and resistance levels? How do you use this technical analysis tool to find exit and entry points? Well, there are two main support and resistance trading strategies – Range trading and breakout trading.
The first method for using the support and resistance trading indicator is to identify a range on a chart and buy the asset at the support level and sell it at the resistance level. By using this support and resistance trading strategy, you essentially believe that the market is in equilibrium and the price action is expected to stay in this range for a while.
The second method is known as breakout trading and as you may guess, it happens when the price breaks above or below the support and resistance zones (usually, with high trading volume and at times of market news). Therefore, a breakout forex trader will typically enter a position when the price moves beyond the support or resistance levels. By doing that, the trader predicts that a trend reversal will occur, which signals the starting point of a new trend. As investment advice – The longer the range, the longer and more violent the breakout.
Keep in mind that you can combine these two support and resistance strategies. If, for example, you focus on one currency pair and it is trading inside a range, take advantage of trading the range. It is a great trading strategy, especially if you are able to place the support and resistance indicator levels in the right places. Then, when the price rises or falls below or above the support or resistance lines, switch your trading mode and change your strategy to breakout trading.
Using support and resistance levels is one of the most common and effective technical analysis tools to trade financial assets when mastered. It is simple, easy to see, and effective. No complications like other technical analysis tools. And the good thing is that many forex traders and market participants use support and resistance levels strategies, which makes these lines psychological levels, especially in the forex markets.
When plotting support and resistance lines, you don’t want the reflexes of the market. You only want to plot its intentional movements. It might also be useful to combine support and resistance trading strategies with other indicators like moving averages, volume indicators, RSI, and Bollinger Bands. Moreover, when you learn how to use Fibonacci retracement levels on chart patterns, support and resistance trading can be even more effective in forex trading.
But don’t worry, with a little practice, you’ll be able to spot potential support and resistance areas with one eye closed!