Lesson #20: How to Use Support and Resistance Levels in Your Trading Strategy

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Greetings, my friends! I believe that the lesson on the support and resistance levels in the forex market is the most valuable and necessary in terms of practical application. When I was designing my course and figuring out things that were important to deliver to my readers who did not steadily benefit, I came to understand why this lesson would become the key one.

First, I see no point in ruminating over the terms “support” and “resistance” in terms of the financial markets. Any trader (even a budding one) should have already noticed that and definitely tried to trade the levels, unconsciously though.

 

Second, I will do my best to focus on the myths concerning the support and resistance levels that are put into the heads of fresh traders. The stereotypes of the essence of the lines appearing on the charts make the traders think in a flawed way, which is why they will consistently lose their money.

Third, it would be quite silly to talk about one specific outcome while discussing methods support and resistance level determination. In lesson, I will examine several unrelated methods. Apart from that, I would like my readers not only to pick one of the proposed techniques but also to go deeper and understand the the basis for its principles.

Please, read the article to the end and do not skip the important conclusion.

Why Do the Support and Resistance Levels Even Exist?

Nobody knows. More truly, I don’t. In fact, every trader has their own explanation for why the price stops near a line. Nevertheless, there are many explanations of why the support and resistance levels in the literature and articles that I would like to discuss with you. I have made my own list of the funniest explanations.

  • All major players follow the common and well-established rules of technical analysis. That is why technical analysis still works though it was invented over 100 years ago. It is called the self-fulfilling prophecy.

The idea of the major players following some written (or unwritten) rules on the different markets terrifies me. Of course, it is hardly possible. In my perspective, the opposite is true. The major players keep laying snares for one another trying to open a position at the expense of other players’ mistakes. I have already spoken about opening a position in the lesson on the order types.

I’m sure that, if a major player knew the rules that other players follow, he would definitely use it to his own benefit. Here I am talking about the support and resistance levels. I agree that many traders have a similar vision of the basic operating principles and the market. It would be naïve to think that all the traders see the market the same way and make the same trades simultaneously.

  • Any major market player is under control of the puppeteer (the players are known as the puppets), who plays around in the market and consequently sets the levels.

 

There are groups of traders who are truly obsessed with the idea of the puppeteer. They believe that there is some entity with limitless liquidity that is able to move the market in any direction at any time and make the small players lose their money. I’m going to say a few words that will describe my position. Here they are: I do not believe in puppets!

I have already confessed that I have no idea why a level may appear. Lucky for me, I have no troubles in making money with trading because of that.

I also believe that one cannot understand the true market psychology sitting in front of the computer in slippers. If you want to get at least a tiny glimpse of the major players’ vision of the market, you must get to the heart of Wall Street, visit the CME, or work as a trader in a largest investment company. This is the only chance you have to understand the principles that a major player follows while opening and closing positions. Everything else is just your factoids that may or may not match reality.

  • The support level becomes the resistance level (and vice versa).

Another popular myth is that the support level becomes the resistance level after the breakout. I don’t really see how that is even possible. Let’s imagine that there is a support level, near which the price is consolidating. We will most likely see the double bottom pattern, which means several bounces from the line. If we connect the lows, we will get the desired support level.

уровень поддержки

Now, let’s think logically. If the price commonly changes direction several times in the small range, then there are a large number of purchase bids (in our case) of the asset. It means that demand exceeds supply at this level.

Let’s suppose that the bears win. They bought out all the long positions opening orders, the bulls had no strength to keep the level, and the price fell down. A breakout happens at the support level.

They key question is why the old support level will become the resistance level for the bulls when they eventually are able to seize the initiative and direct the price upwards, given that the bears were getting the short positions earlier in this range and walked the walk. How would the new selling orders appear on the old level? I don’t know since I find the idea of the support level becoming the resistance level wrong.

False Breakouts of the Level

False breakouts of the level is the exception, which is the most common trap for the traders. If you have studied the balance between supply and demand of the market, you already have a clue what happens when a breakout happens.

Let’s recall our knowledge on technical analysis. I never mentioned the rules you might hear on the various forex trading webinars but if you have ever attended one, they should have definitely taught you to set the stop loss orders above the resistance level and below the support level. Let’s envision a scenario in which the price is near the resistance level and you have opened the short position waiting for the downward bounce and set the stop loss order at 5 points above the line. One hundred thousand traders have done the same thing. What do we get in the context of supply and demand?

уровни поддержки и сопротивления

There are many short positions below the resistance line and a huge amount of long positions (the stop loss orders) above the resistance line. In other words, if the price break through the level, it will be fueled with the intense beam of the broken stop loss orders (the opened purchase orders). This is one of the reasons why the market moves more quickly in case of the breakouts.

Apart from the broken stop loss orders, there are traders who start to trade the breakout of the level. They are increasing the trading volume for the purchase since they are sure that the impulse will keep going.

That’s what happens unless a large bear comes to play. This player is buying out the long positions, forming a strong position and ready to pay the price. He gets the price back and (if there is no stronger bull) crashes the quotation until he faces stronger resistance.

ложный пробой на форекс

I should remind you that false breakouts are a great signal to enter the market. Take a look at the chart and figure out the safest moment to open the positions. Think about how you can trade the breakouts with several pending orders in order to offset risks. I would like to give you an example of a trading approach.

Open the pending buy stop order at the breakout of the support line.

At the moment of the breakout, set the stop loss order at the closing price and the pending sell stop order below what is now the resistance level.

When the stop loss order and opening the sell stop order is done, set the stop loss order above the maximum price reached after the breakout.

Is It the Support Line or the Support Zone?

Another good question while trading is whether we should treat support and resistance as lines or zones. It is actually a simple question. When we are creating the levels, we use the line tool most of all. That is why we got used to calling it “the support line.” However, not all of the extremes lay directly on the line. Moreover, many traders set the stop loss orders not firmly above/below the line but at 5-15 points distance from it. Thus they get a slight increase of trade risk and significantly reduce the amount of the non-profitable trades by avoiding closing the transactions because of the price touching the stop loss order and moving in the right direction without your input.

Many traders find it more comfortable to mark the levels with the Rectangle tool and use the price range instead of the line since they may see the trend change on the price range.

The key idea of this part of the lesson is not to pick the tool you may use for drawing the levels, but to understand the difference between the line (a precise price) and the price range.

The Price Always Moves Level-To-Level

I can’t say for sure, but I believe it’s wrong. From my perspective, price behaves irrationally most of the day and the key things such as a trend or a trend switch happen only when the market gets fuel, which, in our case, comes from the major players.

Of course, if you take a glance at the long-period chart, you can mark some specific zones, in which the price has consolidated and then suddenly gone upwards or downwards. However, if you take a closer look, you will find small movements, which are quite difficult to trade and absolutely impossible to explain.

My trading strategy is to determine the moments when the dust has settled, so I can see a familiar pattern, which will follow a familiar pattern and will bring me a profit.

Let’s talk about some applicable stuff, which is the way to build the support and resistance levels.

How Do We Determine the Support and Resistance Levels?

Now it’s high time for the piece de resistance of the lesson! We are going to look into the working methods of building support and resistance levels.

  • Exogenous factors

I decided to start with the exogenous factors that are the less-obvious source of information about the trend switch. The most remarkable example I can think of is a trading halt on the stock exchange. Budding traders may be confused, but the seasoned traders are definitely smiling right now. We are talking about the Black Monday, Tuesday, Friday, etc. Those are the moments when the price of an asset plunges. The stock exchange follows regulations and halts trading when price is collapsing. For instance, it happens if the price collapses over 15% a day.

Another example is the statements by the representatives of the central banks and other major institutional players about the forthcoming purchase or selling of the foreign currency. Naturally, such statements cause a great influence over the investors but you still need to pay attention to these levels.

  • The chart patterns

I don’t really want to repeat what we have discussed in the lesson on chart analysis of the forex market. Long story short, we connect the extreme points (the lows and the tops of the candlesticks) and form a specific chart pattern. We may single out the following main approaches:

  1. Connect the lows and the tops using the candlestick shadows.
  2. Determine current trend direction.
  3. Trade bounce/breakouts/false breakouts of the level.

We are talking about the number sequence discovered by Leonardo Fibonacci that is applicable to many natural phenomena and spheres of life. This number sequence is formed by the simple formula which is every next number in the sequence is the sum of two previous numbers. As the result, we get the following sequence:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144…

The Fibonacci sequence contains one more incredible pattern. If we divide any number by the next one, we will get 0.618. As a result, we got several important values that traders later started to use as the retracement level in the directional movement range.

Of course, we do not need to calculate fractions. We may use the built-in Fibonacci Retracement Tool of the MT4 Platform.

сетка фибоначчи

The Fibonacci Retracement tool has the marked retracement levels, which are 0.236, 0.382, 0.500, 0.618, and 0.764, and now we only have to figure out how to use them. Each Fibonacci Retracement level is a support level in case of the uptrend and a resistance level in case of a downtrend. We can think of several strategies to work with these zones and I would like to focus your attention to the key aspects of working with the Fibonacci grid.

сетка фибоначчиThe market often works off the Fibonacci Retracement levels well. The key task of a trader is to stretch the grid on the chart.

In theory, a trader should stretch it from the beginning of the trend till its end, that is, between the limiting opposite extreme points.

It means that a trader should accurately determine the end of the trend and its switch. It is quite a task to do that without using any other analysis methods, which is why few traders build their trading strategies using merely the Fibonacci tools. Many traders believe that it would be good to add the candlestick models that allow seeing the trend switch by the specific candlestick formation. I can only advise you to test various options.

  1. Using the Fibonacci Retracement levels cannot guarantee you the accurate pip-to-pip bounce from each level. You need to know how to work with these zones the same as with the support and resistance lines created using different tools. You can trade bounce, breakout and false breakout on the retracement levels 0.382, 0.500, 0.618 and other levels. I recommend you take the time to perfect each of these scenarios.
  2. You can apply the rule of the bigger timeframe (the larger the timeframe, the more technical the market is) to the Fibonacci tools. I think that D1 timeframe is the best one for working with the grid.
  • The levels are created on the basis of the indicators.

We have already spoken about the basic principles of the indicator trading in a previous lesson. Working with the indicator levels is no different from any other. The key feature of the indicators is that they are redrawn with each new candlestick. This feature aggravates calculations a bit for the trader and brings in the negative quotes to the trade. You do need test the indicators but please perform that only in the strategy tester imitating the chart overlay in real time.

  • The levels are created on the basis of the oscillators

If you have missed the lesson devoted to the oscillators, I recommend that you go through it right now. The key feature of this approach is that we create the support and resistance levels following the classic canon of chart analysis though we do this on the oscillator’s line that moves in the range from 1 to 100 instead of the price chart.

  • Round numbers

Another optional rule of drawing support and resistance lines is the price reaction while reaching a round number such as 1.5000, for example. Some traders consider the round quotation only those that are multiples of 1000, while others use multiples of 500. Nevertheless, in most cases, the market treats such quotations as the levels. This phenomenon can be considered a part of market psychology. You should look at the charts of several instruments and check the price behavior while reaching the round numbers.

I think we should finish our lesson on the support and resistance, but we may also discuss it in the comments. In the meantime, let’s make some key conclusions:

Key Conclusions of the Lesson

  1. The higher the timeframe is, the stronger the level.
  2. The more extreme points you see, the stronger the level.
  3. The key task of a trader is to find patterns. The reason for their occurrence does not really matter because, even if you think you have found the right answer, you may still be wrong.
  4. You should test most of the trading strategies only in the strategy tester mode that imitates drawing of the chart in real time.
  5. It doesn’t matter how exactly you are determining the support and resistance levels. The trading mechanics remain just the same and you still trade breakouts, false breakouts and bounces.

Sincerely, Pipbear

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