What Is Support and Resistance?

Support and resistance are price levels where a market tends to change direction consistently. Think of support as a floor beneath the price where buying pressure typically overcomes selling pressure, causing the market to bounce higher. Resistance acts as a ceiling above the price where selling pressure typically overcomes buying pressure, causing the market to turn lower.

Rather than exact price points, support and resistance are better understood as zones where price reaction is likely. This is because markets aren't perfectly efficient, and different traders may identify slightly different levels based on their analysis.

Why Do Support and Resistance Work?

Support and resistance levels work primarily because they are visible to many market participants. When a significant number of traders identify the same level, their collective actions create a self-fulfilling prophecy. As price approaches these levels, buying or selling pressure intensifies, causing predictable reactions.

Consider a stock that repeatedly struggles to break above $50. This happens because:

• Traders who bought at higher prices look to sell and break even
• Short-sellers enter positions, anticipating a rejection at the level
• Traders who missed earlier opportunities set limit orders to sell
• Algorithmic systems trigger sell orders based on historical price action

The combined effect of these actions creates substantial selling pressure around $50, reinforcing the resistance level.

Time Frame Significance

Support and resistance levels from higher time frames (daily, weekly) generally carry more weight than those from lower time frames (1-minute, 5-minute). This occurs because higher time frame levels are visible to more traders, including institutional investors who move larger volumes.

For example, a major support level visible on a weekly Bitcoin chart might attract massive buying from long-term investors, while a support level on a 5-minute chart might only influence day traders with smaller positions.

Common Misconception: Multiple Touches

A common misconception is that support and resistance levels become stronger with more touches. In reality, the opposite often occurs. Each time price tests a level, some of the pending orders at that level get filled. With fewer orders remaining to support or resist price, the level actually weakens with repeated tests.

This explains why markets often break through a level after testing it multiple times – the buying or selling pressure that initially defended the level gradually diminishes until it can no longer hold.

Types of Support and Resistance

Horizontal Support and Resistance

Horizontal support and resistance levels are the most common and easily identifiable. They form when price repeatedly reaches the same level and reverses.

There are two primary approaches to trading horizontal levels:

1. Trading from the same side: This involves buying at support and selling at resistance, expecting the levels to hold. When using this approach, levels with fewer touches are often more reliable, as they haven't been weakened by multiple tests.
   
   For example, if crude oil has bounced off $70 once or twice, a trader might buy when price returns to this support, anticipating another bounce.
   
   
2. Trading the flip: This means trading the level after it's been broken – buying former resistance that now acts as support, or selling former support that now acts as resistance. When using this approach, levels with more touches before the break are often more significant.

When identifying horizontal support and resistance, always start with higher time frames like weekly or daily charts before moving to shorter-term periods. This ensures you're aware of the most significant levels that could influence price.

Additional price points that often act as horizontal support and resistance include:

• Round numbers ($50, $100, 1.3000)
• Opening prices of new weekly, monthly, or yearly candles
• Previous significant highs and lows

Diagonal Support and Resistance

Diagonal support and resistance, commonly known as trendlines, connect a series of higher lows in an uptrend or lower highs in a downtrend. Unlike horizontal levels, trendlines illustrate the direction and angle of the trend.

Trendlines can be more subjective than horizontal levels since they require at least two points to draw and different traders might connect different swings. When drawing trendlines:

• Focus on the most obvious price swings that clearly define the trend's path
• Aim for clean lines that touch at least two, preferably three, swing points
• Remember that steeper trendlines are more likely to break than those with moderate slopes

Like horizontal levels, trendlines can be traded from the same side (buying uptrend lines, selling downtrend lines) or after they break. And similarly, trendlines with more touches tend to weaken rather than strengthen.

Trendlines provide valuable guidance during pullbacks in ongoing trends. When price pulls back to touch a trendline in an uptrend, it often offers a potential entry point to join the trend's continuation.

Dynamic Support and Resistance

Unlike static horizontal or diagonal levels, dynamic support and resistance levels move with price over time. These levels are typically created by technical indicators that adjust based on recent price action.

Dynamic support and resistance levels are particularly useful in trending markets where static levels might be left behind as price advances or declines.

Practical Applications

Identifying Potential Reversal Points

Support and resistance levels help identify where price might reverse, allowing traders to anticipate potential turning points. By recognizing these levels in advance, traders can prepare for possible trade opportunities.

For instance, if a stock is approaching a major resistance level, a trader might prepare to:

• Take profits on existing long positions
• Look for reversal patterns that could signal a short entry
• Adjust stop-loss orders on current positions

Setting Entry and Exit Points

Support and resistance provide logical places to enter and exit trades:

• Entries: Traders often buy near support or sell near resistance when expecting the levels to hold, or enter after breakouts when levels are violated
• Exits: Taking profits near known resistance (for longs) or support (for shorts) improves the probability of exiting at favorable prices

Determining Stop-Loss Placement

Support and resistance levels offer natural places to set protective stop-loss orders:

• For long positions entered at support, placing stops just below the support level protects against failed bounces
• For short positions entered at resistance, placing stops just above the resistance level guards against failed reversals

Confirming Breakouts and Breakdowns

When price breaks through significant support or resistance, it often signals the start of a new trend or the continuation of an existing one. However, false breakouts are common, so many traders wait for confirmation:

• Volume increase during the breakout
• Price closing beyond the level (not just touching or slightly piercing it)
• A retest of the broken level from the opposite side

Key Takeaways

• Support and resistance are zones (not exact lines) where price tends to reverse direction
• Higher time frame levels carry more significance than lower time frame levels
• Support and resistance levels generally weaken with multiple touches
• Horizontal, diagonal, and dynamic support/resistance each offer unique insights
• Starting analysis with higher time frames before moving to lower time frames helps identify the most significant levels
• Round numbers, pivots, and opening prices often act as important support/resistance

Next Steps

In our next lesson, we'll explore the concept of supply and demand zones, which builds upon support and resistance but focuses on the imbalances between buyers and sellers that create powerful market moves. Understanding these zones will further enhance your ability to identify high-probability trading opportunities.