Support and resistance

GBP/USD support and resistance on an uptrend  |  GBP/JPY support and resistance on a downtrend

• Times tested: where a price level has been ‘tested’ (traded) at or near, several times, it may be remembered by participants. For example, traders may not sell into a low or trough if past experience has shown this is not wise.
• Volume spent: following on from the above point, if large amounts of volume have been transacted at or near a certain level, this also tends to be considered and noted by participants in the market.
• Recent trading: the more recent the trading at a certain level, the more relevant the level is to an analysis of market price.
• Round numbers: for reasons more to do with psychology than anything else, traders (and people in general) tend to remember ‘round numbers’.

• Take profit. This is the price at which one takes the profit available on a position. That is, as the price approaches a support (from above), short sellers may take profits on their positions. Conversely, as price approaches a resistance (from below), long traders may take profits.
• Establish a new position near an unbroken level. When the price approaches the support level, a technically driven investor would tend to pitch limit buy orders near and above a defined support and, conversely, would pitch limit sell orders near and just under resistance levels.
• Establish a new position on the break of a level. When a support breaks, one can initiate a short position on the technical expectation that prices will then go onto the next (lower) support level. Conversely, if a resistance breaks, one could buy on the expectation that prices will move on to the next (higher) resistance, if there is one.
• Stop-loss setting​. A breach of a level can be used to limit loss too. Rather than using a break of a support or resistance level as an opportunity to establish a new position, you can also use it to minimise loss. A losing position should be immediately exited. The signal to do so comes from the breach of the support or resistance level.

Once broken, support and resistance levels reverse roles. This is a key aspect of support and resistance identification: once a level (whether support or resistance) is broken, the technical characteristic of the level is reversed. That is, a broken support now becomes a resistance and a broken resistance now becomes a support. Read more about how to deal with breakouts in the stock market.

The first step is to identify the support and resistance that bound the current and recently observed price action. Once this is done, the theory is to pitch the buy and sell orders appropriately, near and above the support and near and just under resistance levels. After this is done, it is prudent practice to apply stop losses (exit orders for example) to the buy (or sell) orders.

Example:

Below is a basic example of a trade plan with a planned limited risk (for example, the difference between our orders and the exit), for a hoped for return. If a trading plan is used and a sell position is entered into, one of two events will occur. They are outlined in the two figures below.

The first figure shows the ideal scenario. A short (sell) position was entered into at the top of the range, near the high and resistance level, with a stop loss on the other side of resistance. From the selling point, the price falls back to the lower end of the range and the take profit order (near support) is triggered and the position is exited with a profit.

The second figure shows the scenario to avoid, but that you must be prepared for. A short (sell) position was entered at the top of the range, near the high and resistance level, with a stop loss on the other side of resistance. From the selling point, the price rises back to, and through, the upper end of the range, instead of falling. In doing so, it hits and triggers the stop loss. This position is therefore exited with a loss.

What happens when the price goes down after short selling  |  What happens when the price goes up after short selling