8.4 Support & Resistance Levels

Support & Resistance Levels - Text Version

In previous lessons, we talked about candlestick analysis as the foundation of price action trading. Now we are going to talk about the best ways to identify and judge S/R levels in a price action context.

Advanced SR Theories

Identifying and judging S/R levels is the number one factor in profitable trading.
While a tradable edge can be created without it by trading only momentum and trend, traders that correctly identify S/R and incorporate it into a “support and resistance” trading strategy can create a much more reliable and profitable edge.
Let’s go through the different methods of identifying S/R, in order of reliability.

Horizontal Price Levels or Zones

The gold standard of any S/R trading strategy should be the horizontal level. Everyone can see it, so there is no ambiguity.
Look for a price level or zone which has held the price at least twice without being breached since then. The more widely the touches are spaced in time, the better.
Measure it to the most touched point and create a zone to the high or low.
The most effective horizontal price levels or zones are support that has become resistance, or resistance that has later become support. Following how these levels change can be a much simpler and more effective way of measuring the health of a trend than using moving averages or other technical indicators.
For example, if resistance levels are breaking and later turning into support again and again, there is clearly a healthy uptrend. When the process starts to reverse, it is a clear sign that the trend may be starting to change.

Fibonacci Retracement Levels

The next most reliable determinant of S/R are the Fibonacci retracements of 50%, 61.8%, and 76.4% of MAJOR moves – that is, moves of hundreds of pips that have occurred over a period of several weeks or, ideally, months. The 50% level is the most effective, followed by the 61.8% and then the 76.4% levels. Do not use the levels on their own to enter trades, but if one of these levels is close to horizontal S/R, then use it to mark the horizontal S/R level as more likely to hold.

Trend Lines

Following FIBs, trend lines are the next most reliable way of identifying S/R levels. Trend lines can be dangerous to new traders as they are often ambiguous, so drawing and using them correctly can be tricky. Therefore we recommend that you practice before risking any real money on trend line trades. Here is a summary of how to play them:
Stick to obvious and unambiguous trend lines. The longer they have held and the fewer hits they have had, the better, although a trend line should always have at least 2 hits.
Draw the lines very precisely, touching the exact swing highs or lows on a short-term chart.
Do not assume a trend line that has just been hit very recently will hold if hit again very soon. It is more likely to break.
The trend line should be meaningful, not just a line connecting any swing highs or lows that happen to fit.
Trend lines that are part of channels are better than single trend lines.
Fast retests of broken trend lines from the other side as a trend resumption signal have a high level of accuracy, and tend to produce excellent reward to risk ratios.

Moving Averages, Pivot Points, and Round Numbers

The least reliable methods to identify S/R levels are moving averages, pivot points, and round numbers. Certain key moving averages can be used to add some weight to S/R levels that are already under consideration. The most widely followed MAs are the 200 EMA, the 50 SMA, and the 20 EMA. The 20 EMA tends to become more important in strong trends or just when a trend is taking off. The other levels are most useful when they coincide with significant S/R levels during a pull back within a trend. It is risky to use MAs alone without any confluence. Generally, the longer it has been since an MA was touched, the more significant the next touch will be.

We’ll end this lesson here. In the next lesson we will bring together all the material from this course and interpret some real historical Forex charts with a price action trading strategy.