Support & Resistance

Support and resistance are levels which interrupt the current trend.

When a downtrend is halted, it is because buyers have been strong enough to absorb the prevailing selling pressure. The same is true when a uptrend is halted. Overhead supply inundates buyers, and price reverts downwards.

Price gravitates between the supply above it, and the demand below it - it ranges. It does this until one side overwhelms the other, and, at which point, there is typically a large continuation move.

When we draw support and resistance levels on the chart, we look for areas where the bulk of the candles stopped, rather than at extreme prices. Extreme points (large wicks) represent panic and forced liquidations. The edge of the range is where enough traders have changed their minds to reverse the prevailing direction of price.

An efficient method of doing this, is to start on the monthly chart, and look for any levels, (usually opens & closes, rather than highs & lows) that jump out at you. You can then go down the timeframes to the weekly and then the daily, refining your levels.

When a level of support or resistance is broken, there is often an aggressive move in price.

We can think why this might be; Traders are constantly watching price, trying to place themselves on the correct side of the next move. If I am buying a level of support, the rationale is that there has been previous demand at this level. Everyone else in the market also knows this. This means buyers have limit orders waiting at this price point, and sellers anticipate this, and close their shorts, taking profit. This profit taking of course turns into market buy orders (think back to market micro-structure), and this absorption of selling, combined with market buying should halt the downward movement in price, sending it back upwards.

IF however, price continues downwards, I as a buyer now start to doubt whether this level of support still has sufficient demand to absorb those sells. Either sellers are not taking profit, or there is a lack of demand - others in the market do not want to buy at this price. Now I have to cut my losses and exit my long (perhaps even my stop-loss gets hit). I have now been turned from a buyer into a seller - I too start to believe price is more likely to go down than up, and so do a lot of other traders. It is this change in behaviour, turning a bull into a bear, or vice versa, as well as the forced closing of positions, that causes a rapid movement in price once this support barrier is broken.

We can then understand why levels of support and resistance often change roles after they are broken... That is, previous levels of support become resistance, and resistance becomes support. Why? Well, continuing on, I am now a seller, and perhaps after a significant price move, I decide to take profit and close my short. At the same time, others think price is currently a bargain, or the asset is undervalued. New buying enters the market and price reversed upwards. Other traders who hadn't yet taken profit on their short, now sense strength in the market - they decide they should close their short as well so as not to hold during a round-trip. Now, If someone bought because they believed the asset was undervalued, where would they sell? Where is fair value? Well, it might seem wise to sell at a level of previous supply, and where is that? Well it's our previous level of support, where demand was insufficient and buyers were overwhelmed by supply.