He who lives by the crystal ball will eat shattered glass, said Ray Dalio. The ways to analyze the market are increasing by the day, all for the purpose of giving traders the foundation for trading. The more knowledge one has, the less likely he/she is going to rely on sentiment or intuition.
Support and resistance have emerged as two of the most discussed aspects of technical analysis. The two terms refer to the price levels that traders use in the chart to determine certain patterns. These levels are important because they can stop an asset from getting pushed in a certain direction.
Support and Resistance Differences
Although support and resistance may come in many forms, they can be defined as follows:
Support is a price that has not come down for a while. Such a pause in price movement is triggered by a higher demand or buying interest. Support always occurs where we expect to see a downtrend and where buyers tend to enter the market.
Resistance is an indication that an uptrend may pause for a while owing to a concentration of supply. Resistance also signifies that certain asset experiences difficulty breaking through, which may result in a potential fall. The greater the number of times the index or stock has tried to break through the resistance, the stronger the resistance in question is.
Both support and resistance are confirmations of supply and demand levels that can be identified with the use of trendlines and moving averages.
Supply and Demand vs. Support and Resistance
All support and resistance levels result from supply and demand levels. When the price of an asset drops, demand rises, forming the support line as a result. Conversely, prices increase causing selling interest, which leads to the formation of resistance zones.
Whenever a price reaches support or resistance, it can either bounce back in the opposite direction or break through the price level until it reaches the next support/resistance level. These support and resistance zones can thus serve as potential entry or exit points.
Whether the price bounces off or breaks through the support or resistance lines, traders can always get an idea of the direction towards which the price is heading and have their theory confirmed or refuted promptly.
Should the price move in an unfavorable direction, traders can close the position at a small loss. However, if the price moves to the trader’s benefit, the entire trade can turn out to be quite rewarding. This idea gives birth to many reversal strategies.
Now that we understand what happens when an asset tests the support line, we need to address possible problems in trades that use support and resistance as a tool to identify price action.
First of all, support and resistance levels are one of the key concepts used by technical analysts. As their popularity is undeniable, so is the fact that they can create hotspots in the chart. If your support line is easily created by most market participants, you will surely see the heightened concentration in that area of the chart. And, the more traders rely on the use of support and resistance, the greater the chance that the big banks will step in and manipulate the price.
Secondly, many traders like to use support (and resistance) lines for predicting where the price is going to go. Unfortunately, we cannot know if there will be any reversals or breakthroughs in advance. What we can quite often attract, however, is an uncontrollable and unexpected change in price triggered by an elevated concentration of traders in a specific price level.
Thirdly, there is a rise in the number of social media accounts that claim they know where the right support lines are in the chart. These posts and offers are used as fishing hooks intended to lure people to trade based on the information provided for which the authors receive payment. Do not trust all products you find online just because someone claims to know exactly what you want to hear.
Next, support and resistance do not function equally well in different trading markets. These terms may serve stock or crypto traders much better than currency traders for example. Some brokers’ websites contain information on where support and resistance lines can be found in the chart, but do not forget that these companies earn money when the price moves in the exact opposite direction from where you would want it.
Also, if you use support lines in combination with another similar tool, you may increase your susceptibility to external influence (i.e. large banking institutions). The more you rely on the tools the majority of traders prefer, the greater the chance of your trade being whipsawed.
And, if we see several support lines in the chart, which one are we supposed to use? How do I know that I have chosen the right one?
Last, if there are variations in the degree of my success, how can I know that support (and resistance) is a reliable tool for sure?
When you test how support and resistance works, make sure to take detailed notes of all of your trades, including the total wins and losses. Sometimes, we get a feeling that something is a great tool just because it once brought us some good results.
Traders need to feel certain that the tools they use in trading are going to give them consistent results – both in terms of wins and losses. If you get one good win and then take five consecutive losses, your account will suffer. You may have a problem even with fewer losses if they end up cutting your entire account in half. No win can compensate for such a loss percentage, and no tool should be trusted if it leaves room for such scenarios.
What is more, the trading community seems to love support and resistance lines, but the fact that there are very few critical observations of this tool should raise questions.
If you are a beginner, you should definitely pay attention to the testing phase and record every step diligently. You must know if your support and resistance lines are going to serve you or make your account suffer.
However, if you find your support (or resistance) lines to provide you with continuous success, there is no reason for you to question their worth any further. If you have good results, you need to keep that skill consistent. Having a hunch could be a skill if you can do it time after time, the lingering question remains: is that talent going to vanish as you change psychologically and physically?