How to trace the supports and resistances in trading?
The first and certainly one of the most essential thing to understand is that you have to trade prices. This implies the existence of different levels on the market. These levels are called ”supports” and ”resistances”.
Supports: a support is a threshold or technical level at which buyers find the prices attractive and decide to enter the market at the time of purchase, driving up prices.
Resistance: a resistance is a threshold or technical level at which sellers find prices attractive, and decide to enter the market for sale, causing prices to fall.
What we need to understand is the psychology behind these technical levels.
The supports and resistances are levels on which the various market players (banks, investment funds but also private traders whether they are professionals or just amateurs) take a position. They are, therefore “psychological thresholds” and are often round numbers or historical levels.
When a support is broken, it very often becomes a resistance later on: this is called a polarity reversal. This is explained by what is called ”market memory”. Indeed, the market, i.e. the various participants who carry out transactions on it, all see the same thing and remember the important technical levels. These levels are therefore recorded by consensus and when prices return to them, it is most likely that a large majority of traders carry out a transaction there: hence a price reaction.
A support that has become resistance: polarity reversal.
Why you should always consider supports and resistances as “zones” rather than fixed levels
Very often, we tend to trace our different technical levels by a fixed line.
However, if the market remembers the old worked levels and has a memory, the levels should always be considered as price areas rather than fixed prices.
The $6,600 – $6,640 zone is a powerful resistance for Bitcoin
In addition, it is interesting to note that the market is often misleading. Indeed, “excesses” are frequent, and prices have very often tended to slightly exceed a technical level before returning to the price zones in which they were located.
This is called a “false break” and is the nightmare of breakout traders.
As can be seen from the price action of NEO cryptocurrency, the market has very clearly “marked” a resistance between $137 and $138.5 but when prices have risen through this area again, the market has done what can be described as an excess by slightly overcoming this resistance and then reintegrating it.
This is generally explained by the fact that many traders go on sale when prices come back on the resistance zone and place their stops above this level: market makers (whose aim is to “seek liquidity”) will therefore very often try to raise prices before they stop. We will come back to this in details in another chapter.
This is why we must always consider the technical levels as “zones” and never as fixed lines. Otherwise, it would be too easy.
Now that we know how to draw “technical levels”, i.e. areas that the market has particularly marked (and which will probably be seen and consequently traded by the various players), namely the supports and resistances, we will look at the most optimal way to trade these levels.
How to trade supports and resistances?
These technical areas are the ones you want to trade. Why? Because these levels offer you, if you trade them in a smart way, a statistical advantage in the market. To understand what a statistical advantage is, I invite you to take a look at the section “statistical advantage”.
On the technical area of $11,600 – $11,800, prices encountered a selling consensus: resistance could be traced. Thereafter, prices dropped to the support area of $9,400 – $9,300. Then the prices rose again to the old resistance and were rejected downwards indicating that the sellers were still holding this area. A trade was possible: a sale with a STOP LOSS above the last highest and a TAKE PROFIT at the last resistance level allowed you to obtain a correct ratio of more than 3 to 1. It is by placing your trades on support and resistance levels that you will obtain most probabilities of success. These are also areas that will offer you the most important ratios.
It is important to understand that in both swing trading and intraday trading, the ratio (”risk / reward’’) is one of the essential factors, if not sinae qua non, of a winning trading. It must be as high as possible while remaining objective, which is often difficult to do.
A basic strategy for swing / day trading
Let’s now take the previous trade example and implement it in a global strategy. This strategy, very common, is used on all types of trading and gives particularly effective results for swing / day trading traders.
–> First: define a general context to draw a bias (rather buyer or seller)
First, it is necessary to define a general framework to know in which direction one will carry out one’s next trades. If we take the example of a swing, we start by looking at a rather high unit of time, such as the daily one. We plot our technical levels on a daily chart (each candlestick represents one day of quotation). We plot this level by considering that the rejection zone is located at the new beginning of the wick (buyers / sellers push back the prices until the candle closes).
A resistance can be traced: we place an alert on our platform on the price of $11,600 to be alerted when prices come to pick up this area.
Our alert is triggered, and we receive an e-mail / SMS from our trading platform indicating that prices have risen to an interesting technical level: they are once again facing the big resistance we had traced. Two indecision candlesticks are emerging on a daily basis indicating a significant probability of market reversal because we are in an important technical area.
This step is essential because it allows us to define our bias: we will be bearish on this trade because the market is undecided on a previously identified technical level.
It is now interesting to look at what is happening on the lower time units to get more information and know if we want to take this trade, or not.
–> Second: go down on lower time frames to see more clearly and understand price action
This graph in H2 allows us to better understand the different forces involved. Since we are below the resistance, buyers will probably cut out their positions to cash in profits, which will tend to slow the price increase.
In addition, there are sellers who will most certainly enter into a position to sell the market. This double pressure will probably have the effect of driving prices down and it may be interesting to try to enter the position using an indicator, oscillator or any other data that will confirm our decision.
–> Third: we are looking for confirmation before entering the position
We do not enter into a position randomly. We will wait for confirmation through prices. For this, there are thousands of different possibilities: Fibonacci ratios, Gan, Bollinger Bands, moving averages, pivot points, indicators / oscillators and so on. Personally, I very often use Japanese candlesticks to get into position. For this example, we will use the most widely used indicator in the world of trading to ”confirm” our sales bias: the RSI.
Indeed, a divergence is now clearly visible on the RSI.
We, therefore, decide to sell this resistance with a stop above the last higher point. Our objective has also been traced on a daily basis and it is the old support we designed, between $9,400 and $9,600. We, therefore, place a limit order on this price range at $9,500. This trade allows us to obtain a ratio of 3 which, in swing trading, is correct.
Prices are falling rapidly, showing that we were right on our bear bias: sellers are still holding on and zone and having resold the resistance, have caused prices to fall. Our limit order is executed at $9,500 and we get out of the market with this nice gain.
Of course, this trade easily could have been a loser one. There is never any certainty of future price action. No one, until proven otherwise, is able to predict the future.
But by placing your trade on interesting price zones, supports and resistances, it simply allows you to have a correct probability of success for your trade and to have a ratio higher than 1. You have what is called a ‘‘statistical advantage” or ”mathematical advantage”.
The rest belongs to the market.
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