I try to keep up with requests from readers on subjects to cover in Maven, and one that’s come up a few times recently is “back to basics” support and resistance levels – you know, the good old-fashioned horizontal ones.
And watching a certain forex chart this week, led me to think that today would be a good day for a look at these important levels.
Support and Resistance – less complex than you think
Support and resistance are nothing more complicated than price areas a stock, index, currency (whatever you’re trading) struggles to move through.
As the price moves up, sellers come in and halt its progress … as the price moves down, buyers come into the market and give it a boost.
These magic support and resistance areas appear all over our trading charts – and are among the most useful and widely applied tools in the trader’s repertoire.
Let’s take a look at that forex chart I was talking about …
Here’s one I prepared earlier
This is what’s been happening to the USD/CAD for the past year …
The currency pair has been stuck in a trading range between around 10000 and 10800 for the last twelve months. And by simply drawing two horizontal support and resistance levels on this chart show, we can demonstrate just how much profit potential this scenario presents.
Long-term, the resistance is around 10800, although in recent months, the price has been struggling around the 10700 area.
And support is holding at around parity (10000), with a short dalliance below this level in April. (I’ll talk more about the lure of round numbers another time.)
There are a couple of useful tricks I find helpful when drawing in support and resistance lines …
The first is to use a line chart rather than a candlestick chart – this is especially beneficial for longer time frames. By only showing the closing prices, this cuts out some of the knee-jerk spikes you find in candlestick charts.
The second is to think of support and resistance levels as “areas” rather than “lines”.
Take a look at this image of the same price chart, with the support and resistance areas highlighted in blue:
Personally, I find doing this more helpful than hopelessly trying to join up peaks and troughs with a ruler.
Anyone for tennis?
So, my resistance level falls at around 10700, and my support at around 10000.
So, I draw these lines in, and all that remains is for me play forex “ping pong” between these two levels – buying when we’re at the bottom of the range and selling when we’re at the top.
Right?
Well, not exactly.
If I’m going to use these support and resistance levels for entry and exits, I need to consider the thousands of other forex traders who’ve had exactly the same great idea as me …
All this traffic means that prices will inevitably get a little “messy” around these support and resistance areas. For that reason, we need to give our trade some room to breathe, with entry and exit levels within the channel we’ve drawn, and stop losses outside the channel.
Again, I find that thinking of the support and resistance “zones” helps me to avoid the common pitfalls of setting my stops where they can be too easily knocked, and my profit targets just out of reach.
The other thing to think about before we assume that this chart is about to bounce up to 10700 is – what else is affecting this price Luckily, when it comes to the Canadian Dollar, there’s an easy target – oil.
Canada is a big oil producer. The US is a big oil customer. So the equation is simple.
A quick look at Crude oil prices (another instrument that’s been stuck in a range in recent months), shows the oil price at the top of its range. So, if crude prices are on the turn, it’s not unreasonable to expect the value of the Canadian dollar to do the same.
At the moment, I’m watching and waiting – not forgetting the non-farm numbers out this afternoon, which may trigger some action.
Broken or tested?
The big question when it comes to support and resistance levels is: how do we know if resistance is broken or merely being tested?
Unfortunately, there isn’t a cut-and-dried answer to this one.
Some traders will tell you that support or resistance is considered broken only if the price actually closes past that level. So, either look at the closing price on the candlestick, or (as I suggested earlier) use a closing-price line chart.
And, again, try not to get too hung up on numbers and “levels” – support and resistance are not exact numbers. Instead, look for those sticky “areas” on your chart, where the peaks and troughs congregate.
I tend to think that judging support and resistance levels is a bit like finding your way to the bathroom in the dark – the better you know your route, the more accurately you’ll be able to do it. But, even if you know the way and have done it a thousand times, you still sometimes come off with a stubbed toe.
