Education

Understanding forex basics: Resistance and support

Support and resistance explained

One of the most foundational aspects of technical analysis is
support and resistance levels. These levels are key as they offer traders
obvious places to limit and define their risk. There also represent places that
price should not go if a trader has correctly analyzed their trade.

Take your trading to the next
level

These places are defined by support and resistance levels. Once
a trader has decided which currency pair is suitable for trading the next
decision is where and how to make your entry. This article will consider three
key areas of Support and Resistance that traders use as part of their technical
analysis in order to make that decision.

Horizontal
Support and Resistance

Arguably
the most widely followed aspect of technical analysis is horizontal support and
resistance levels. Horizontal support and resistance levels are key market
levels where price has shown reaction in the past.

As
price moves towards those levels, at which price has reacted previously, they
become significant as points in the market dividing buyers and sellers. Think
of these levels as ‘zones’ rather than ‘lines’. You might find it helpful to
think of these zones like a fat man’s stomach.

You
can push in quite a bit into a fat man’s stomach before you reach the point you
can’t push anymore. In a similar way horizontal support and resistance levels
provide a general zone or area where price will react.

Some
traders go wrong when they consider these levels as only being in play at a
specific level. They are not to be viewed as exact levels. Sometimes
price will appear to stop short 10 pips before the level. Other times price
will overshot the level by 20 pips before finally respecting it.

They
are not strict levels, but rather key zones. The general rule of
thumb in using these levels is to buy from support (with stops the other side
of the level) and sell from resistance (with stops the other side of the
level). These levels are also good places in order to take profits as price
will often reverse at key horizontal support or resistance levels, if only to
retrace before continuing the move, so taking partial profit or moving
positions to break even makes sense.

Moving
averages

Another
basic and common place to find support and resistance is with moving averages.
Now moving averages are slightly different to horizontal and support levels as
they can, at times, be respected quite accurately.

Although
there will be occasions where the moving averages try to break through their
levels, often the closing price will demonstrate whether the buyers or sellers
have won that battle or not. Two of the most popular moving averages are the
100 and 200MA. By using these two moving averages traders can find excellent
places to limit and define risk.

Looking
at the AUD/JPY currency pair below you can see the 100 and 200 MA acting as
resistance levels on the daily chart as the AUD/JPY pair was in a down trend.
Risk off sentiment and US China trade war rumblings led to a AUD/JPY short
bias. The Moving averages provided places for traders to define and limit their
risk to take advantage of short trades.

Pivot
points

Pivot
points are very similar to support and resistance levels since they are
horizontal levels in the market which are viewed by lots and lots of traders.
In a similar way that Fibonacci levels are respected in the market because many
traders are looking at them, pivot points are widely followed levels too.

Part
of their widespread appeal is that they are calculated in an objective way, so
there is no uncertainty about where they should or shouldn’t be. A
pivot point is formulated as an average of important prices (high, low, close)
from the previous trading period. 

You
don’t have to calculate the pivot point levels themselves since most charting
software will do it for you. You can also install indicators that automatically
chart the levels on the chart. The way to use them is to find a currency pair
that you think should fundamentally move in price. So, for the sake of this
illustration, let’s suppose you have decided that you want to try and swing
trade the GBP/AUD pair long.

You
would then look to buy from either the pivot point or a support level labelled
S1, S2, or S3. Have a look at the chart below to see the pivot points labelled
on the GBPAUD currency pair.

The
key concept to understand regarding support and resistance levels is that they
are primarily used by traders to define and limit their risk. It is not
advisable to just use technical analysis on its own since the market is driven
mainly by sentiment and fundamental analysis.

However,
when there is a combination of fundamental reasons for entering a trade and a
technical place to define and limit risk then this can make for some successful
trades. So, this article has shown you three key basic areas where you can find
support and resistance levels: at moving averages, horizontal support and
resistance levels and pivot points. Take them and consider using them as part
of your technical analysis toolbox.

This article was submitted by LegacyFX.

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