So far, we have been looking at trends and the structure of trends in financial markets that are essential in understanding how asset prices move. We also got a glimpse of the art of charting, the visual representation of prices. Now that you have the basic knowledge, we will give you more tools to tweak your trading, while helping you in finding precise entry and exit points. First, we will take a look at support and resistance levels.
Significant Price Levels and the Memory of Markets
Important levels in the DOW Jones Index, Daily Chart
Everyone who is involved in trading and investing is familiar in one way or another with some of the most iconic levels of the major assets. The $100 per barrel level in crude oil, the DOW 10,000 or 20,000, the 1.00 level in the EUR/USD currency pair—all of these have sparked emotions worldwide, triggering euphoric or apocalyptic visions of profits, inflation, or even wars.
This level of attention and emotion creates extreme situations in markets, but if you take a step back and look at the phenomenon objectively, you will realize that it is the opposite of extreme—it’s perfectly normal. We, humans, use anchors to help us in navigating in the world; it’s just natural that round numbers and special levels have a prominent role in financial markets. This role usually means that more than average players are selling or buying at those levels, creating resistance and support levels respectively.
So what kind of special levels are there exactly? Here is a list containing the most important ones:
- Round numbers
- Previous swing highs and swing lows
- All-time highs and all-time lows
- Previous opening and closing prices
- Range projections
The “memory” of the markets means that previously important levels (like extreme points in the price of assets) will remain later on. Of course, this effect might get weaker by time, but sometimes certain levels from years and years earlier retain their role as support or resistance levels. You probably noticed the previously mentioned swing highs and swing lows in the list and, of course, all-time highs and lows are also swing highs and lows by definition. This could shed more light on why those highs and lows are crucial in swing trading strategies.
Out of these levels, Fibonacci levels and range projections need some explanation. We will talk about range projections in the second half of this post, but for now, for those who don’t know them, “Fibo” levels are “natural” retracements and extensions for a given price movement. They are calculated using Fibonacci numbers and the Golden Ratio that is found everywhere in nature from the shape of galaxies to the geometry of plants. Later on, we will dedicate a whole post to Fibonacci levels.
Using Support and Retracement Levels in Trading
Support and resistance levels are very versatile tools that can be used for both primary and secondary trading signals. The basic premise of these levels is that there is a significant amount of buying power or supply concentrated near them. When the price of an asset gets close to these levels, they “test” the power of the trend with that additional demand or supply.
What does this mean for you as a trader? These levels are possible turning or breaking points that generally lead to heavy trading, significant moves, and sometimes major trend reversals. It is important to note that the underlying trend always deserves priority—in an uptrend support, zones generally hold, resistance zones generally fail. Just because an uptrend runs into resistance or a downtrending asset finds support, the trend won’t change. That said, if other clues suggest a trend change, these levels frequently provide the trigger for the reversal.
Break-out trades in an uptrend
Using these levels to enter a trade is the most effective in the direction of the prevailing trend. As an example, if an asset is in a counter-trend move within an uptrend, a nearby support level could be a good place to buy the asset. Also, if the same asset breaks through a strong resistance zone (see the chart above), it is likely that the trend will continue (of course other factors should be considered as well).
To understand this even more, imagine those traders who are speculating on a trend reversal using the said resistance level. Those players will likely exit their positions as the price rises above the resistance, actually providing additional buying for the asset! That’s why break-outs often lead to explosive moves in uptrends, while support breaks lead to steep losses in downtrends.
Support and resistance levels are also great to select optimal profit-taking and stop-loss orders. Using an uptrend as an example again, if the price of the asset drops below a certain support level that sometimes means that the trend is weakening, at least short-term. Also, if the price approaches a resistance zone, the odds for a correction increase, possibly justifying taking profits, or fully exiting the position depending on other factors.
Trading Ranges and Range Projections
As we stated previously, asset prices spend a lot of time in neutral trends, trading without a clear direction. These consolidation phases mainly happen in trading ranges or other consolidation patterns. A trading range is a zone that is bordered by generic horizontal resistance and support levels. Other consolidation patterns might have different shapes, such as triangles and wedges. We will dive deep into these chart formations in our next posts.
The “classic” range consolidation is a great formation for trend-following strategies, as the borders of the range provide easy-to-identify primary and secondary signals for traders. Another important usage of these ranges is range projection, a technique to identify trading targets using the size of the trading range.
How does that work in practice? The most common method is to project the size of the range in the direction of the break-out and set trading targets according to this possible new resistance or support level. The memory of the markets, in this case, means that traders and trading robots are “used to” the prior size of movements, and as the price approaches the projected level they will assume that the movement will soon end, which will be also suggested by a lot of indicators that were “calibrated” in the prior range (we will explain this effect later on in our posts on indicators).
An example of the range projection method
These projections are usually more effective in the case of long-lasting trading ranges. Also, sometimes it is useful to use secondary range projections as well, doubling the size of the original range, as resistance levels frequently develop near these projections.
As it’s the case with everything in trading, support and resistance levels are not perfect. A lot of times (especially in the days of trading algorithms) the price “overshoots” these levels, as trading robots go wild near these key points. These spikes sometimes lead to false break-out or break-down signals. The good news is that if you are aware of this process, you will be able to benefit from it, even if sometimes you will inevitably be the victim of these “traps”.
Again, respecting the prevailing trend is vital. False break-outs above resistance levels are much more likely to happen in a downtrend than an uptrend, and similarly, break-downs in uptrends are not to be trusted, as they commonly prove to be bear-traps.
False signals in a trading range, within an uptrend
When you are using these levels for trading, especially as secondary signals, it is often a good idea to leave some ground for these false moves by setting the stop-loss or profit taking orders, a bit away from the exact support or resistance levels. Also, buying an asset after a false break-down, or shorting it after a false break-out, is among the highest probability trades out there as those who got trapped will likely exit their positions as the market moves against them.
In our next post on charting, we will take a look at some notable chart formations including tops, bottoms, consolidation patterns, and much much more.
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