Forex 102Lesson 4
What is Support and ResistanceSupply and Demand! One of the basic characteristics thatdetermines the value of a product, commodity and even acurrency, forms an important aspect when it comes totechnical analysis of the forex markets. Prices in acurrency pair tend to fluctuate when there is animbalance of supply and demand. In this article, we’llexplain what supply and demand is and thus eventuallyillustrate the importance of trading with support andresistance and how traders can capitalize on thisanomaly in order to take more effective trades.
What is Supply and DemandSupply is when there is an abundance of a product or when thereare fewer buyers in a market. This scenario results in pricesbeing reduced. Demand, is when there is an abundance of buyers orwhen the availability of the product is much lesser, which tendsto raise the value of the product. Therefore, in forexterminology, when there are a lot of sellers, the price tends todrop and when there are many buyers, the price tends to rise.Supply and demand, in trading terminology can also be referredto as support and resistance.
What is SupportSupport is nothing but a level or a zone where there are more buyers thansellers, thus forming a floor and where price tends to rise in value.Resistance, in forex is where there are more sellers thus resulting in adrop in a price.In simplistic terms, it is ideal to sell at resistance (or supply levels) andto buy at support (demand levels).Support and resistance form an important aspect of trading the forexmarkets. They are not constant and continue to change constantly as themarket dynamics continue to change. Understanding support andresistance is an important concept in trading and it is essential for thetrader to understand these concepts.
Support and resistance levels can assist in various forms oftrading, the most common trading systems of which are as follows:BreakoutsReversalsPullbacksPsychological Support and Resistance levelsTrend line support and resistance levelsTo understand any of the above, we need to first get an idea of howsupport and resistance levels are depicted in the charts.
In the chart above, notice the highlighted areas depict support andresistance, with the red and green arrows. Take note of the greenarrows depicting the support level where price has managed to rallytwice.
Support and Resistance BreakoutsTrading breakouts is an approach when price tends to move within a tight range over an extendedperiod of time. The direction of the breakout, while uncertain can help determine if there are morebuyers or sellers. Or in other words, if a support or resistance level is being formed.The chart below shows how after periods of consolidation or price moving in a tight range, there wasa breakout to the downside. During the process, we notice a moment where price tried to break out tothe upside but failed. Traders without an understanding of support and resistance would have seenthat as a long entry, but soon would have resulted in a losing trade. The trick is to look to themarket structure to the left of the chart.
We notice here how past attempts to break out to theupside failed. Therefore, any attempts to the upsideshould be viewed with suspicion. After a while pricemanaged to breakout to the downside. But this tooshould be viewed with suspicion. The trick is to trade onthe retest of this breakout, which as shown in the chartdepicts how the breakout level has formed resistance.From the chart, we also notice how there was anintermediate support level formed, which is where wewould be looking to book profits.
Trading Reversals with S/R LevelsSupport and resistance also helps with trading reversals. The key to trading reversalsis in identifying past support and resistance levels. In the chart below we plotted asupport level based on previous price action. After a brief rally, we see a downtrendbeing seen on the charts. Incidentally, we see a sharp reversal from the previouslyidentified support level. Notice how price makes a very sharp pin bar to reverse fromthis support level?Without the use of support and resistance, traders would have continued on with theirshorts without knowing how price would have reversed when revisiting the past supportlevel.
Trading Pullbacks to S/R LevelsTrading pullbacks offers an effective way to take a safe trade entry. In the following chart, we showhow in a downtrend, price made several pullbacks right to previous support levels which turned toresistance. These traders would have offered a very safe trade entry with a very strong risk/rewardtrading strategy.If you look closely you will notice how the pullbacks happen into the regions of past support levels.In the above example, we see three such instances which would have offered a great way to trade witha low risk, high probability trading strategy by simply determining the trend and the support andresistance levels.
Psychological S/R LevelsAnother support and resistance levels is thepsychological numbers. The best illustration of thiscould be seen in the USDJPY where it is easier to spot aswell as understand.
In the USDJPY chart above, notice how price reacts to keypsychological levels of 95, 100, 103 and so on?What are psychological support/resistance levels? Psychologicalsupport/resistance levels are nothing but round numbers. For example,1.3 in EURUSD, 1.6 in GBPUSD or 100 in USDJPY and so on are considered tobe psychological levels. These levels however are not support orresistance levels, but in fact can act as either of the two. For examplein the case of USDJPY, notice how the psychological level of 100 actedas resistance earlier on, which in turn became support as price managedto break above it?The psychological support/resistance levels also offer a way totrade and can be used as entry points or exit points for booking profits.
Trend Line S/R LevelsSupport and resistance levels can also be determined with trend lines.In the following charts, we see a down slope trend line. While thetrend lines tend to act as support (in case of an uptrend) andresistance (in case of a downtrend), they also depict the price zones aswell. In the chart below we notice that besides the trend line acting asresistance, they also depicted horizontal support/resistance levels.Look closely at the charts and you will notice how price bounced offthose levels at first contact. Pay attention to the most recent priceaction. To the layman, it might seem as a reversal. But for tradersfamiliar with support and resistance, will know why price bounced offfrom that level, which incidentally was a strong support level.
As can be seen from the above examples, support andresistance forms one of the most basic building blocksof trading. They are also referred to as supply/demandlevels. By having a firm understanding of the supportand resistance levels, traders would be able to improveany trading system that they currently follow.
Therefore, in forex terminology, when there are a lot of sellers, the price tends to drop and when there are many buyers, the price tends to rise. Supply and demand, in trading terminology can also