Support and Resistance Basics

Support and Resistance Basics

 

SUPPORT AND RESISTANCE THE BASICS

When it comes to the pantheon of trading concepts, the most important list of trading elements, understanding support and resistance is King of All Things. Without a deep understanding of what support and resistance is, how to chart it accurately, and the importance of volume, it will be virtually impossible to trade profitably. Commonly referred to as “S/R,” let’s take a deep dive into what it is, what it isn’t, how to interpret it, and how to use it in different trading time frames.

 

SUPPORT AND RESISTANCE: WHAT IS IT?

What is support and resistance? In a word, support and resistance is probability. Every trade thesis needs a data-informed notion of where to enter and exit. For beginners, this is often perceived as a nebulous form of dark magic. How can experienced traders announce when an index is likely to reverse, beginners often wonder. And until you understand the finer points of support and resistance it does indeed seem like some talented traders have located a time machine.

Imagine the typical price action as observed on any stock chart. Price will generally either be rising, falling or consolidating. The massive explosions up or collapses down are typically infrequent and can be considered, for the purposes of the trader new to S/R, outliers. As stock prices either appreciate or depreciate, the price action will run into areas where it will accumulate without further movement in the previous direction. The goal of the S/R game is to mark these areas in various time frames on your chart. If price is rising currently, look back to the most likely area of consolidation that appears above the current price. As price action approaches this previous area, there is a certain probability that price will slow and consolidate around this area. As traders make various decisions, the price will either bounce off this resistance area or continue climbing through it.

Being aware of possible resistance areas when entering a long trade is paramount. Stocks do not go up forever, and if you are aware of a very strong area of resistance approaching you can make the informed decision to sell part of your position or all of it. There are many options. Sometimes traders will sell most of their profitable position as price action approaches resistance and then keep their remaining shares and/or contracts to see what happens as price enters resistance. Perhaps it will in fact reject and the trader can sell at a smaller profit than she sold the bulk of the position for. Or if the price continues upward and clears resistance then she has an even more profitable situation she can reassess as the price heads toward the next area of resistance.

And, the inverse is true if you are looking at a short trade except it is called “support,” and the directional logic is simply reversed.

Additionally, there are other considerations to support and resistance. First, it cannot be repeated enough that no broker will draw your support and resistance on your charts for you. It is imperative that you take the time to chart out resistance on various timeframes and learn how to interpret your lines. Generally speaking, the larger time frame chart support and resistance you see, the stronger the S/R is. A major area of support on the daily chart can be expected to be better respected, and thus stronger, than a major area of resistance on the five minute chart. So, which charts are important to which traders?

This heavily depends on many factors including your intended type of trading. If you are scalping or intraday trading, traders often rely on S/R charting of 1 minute, 3 minute, 5 minute, 15 minute and the hourly charts. Longer-term swing traders may never look below the daily chart. As your trading evolves, you will learn which type appeals to your set of skills and psychology.

Regardless of the type of trading your partake in, understanding and using support and resistance is paramount. Don’t skip learning this important skill.

 

STATIC S/R

Now that you know the basics, be aware that there are subtleties involved in S/R. One of the two major types of S/R is called “static” support and resistance. This is the type of chart S/R you see represented with straight horizontal lines. This will often identify previous price levels that act as S/R, and it generally centers around a price area. You may see, as an example, that stock XYZ hasn’t traded below 92$ a share since last October. And at that same level price consolidated a while until it went higher. This could act as a strong support level, so a trader might place a horizontal line on their chart to signify this support level. Price may never approach this level again; however, if it does you will have the line you plotted (perhaps months ago) reminding you to pay attention to what happened in this stock the last time it approached this level. This works to the upside and the downside, and horizontal lines denoting significant price levels in the past of a stock are known as Static Support and Resistance.

 

A PRACTICAL NOTE

As you might imagine, if you chart enough S/R, your charts can get very busy with lines. In order to keep the data you are displaying easily understandable, it is helpful to come up with your own system regarding how these lines look. In all major brokers, you can choose the color of any line you apply to a chart as well as the thickness and the style (unbroken line, dotted line, dashed line, etc). Some trades choose to use thicker lines for stronger, longer term S/R levels and some apply colors to different time frames to help them know at a glance what they are seeing. These are all customizable by you, so be aware you don’t have to have two dozen identical white lines chopping up the visuals on your chart. Find a system that works for you and use it.

 

DYNAMIC S/R

The other major type of S/R is called “Dynamic” support and resistance. While static S/R does not change and stays steady at a certain price level, dynamic S/R will change. Dynamic modes of S/R include many indicators such as VWAP, and very often it involves moving averages.

A much beloved and often used moving average is the 34 EMA, or exponential moving average. Applying this to a chart will draw a line that denotes the average over the last 34 units per the time frame selected (minutes, hours, days, etc). Often a stock will be seen rising or falling with pullback areas of breathing room that come right down to the 34 EMA. Then it will bounce off of this line and continue in the desired direction before retesting it and bouncing again. When this is observed, a trade thesis might go like this: I will enter the trade when price bounces off the 34 EMA again, and I won’t close it unless a candle opens and closed below the 34 EMA.

This very simple thesis only involves one variable: has the price action breached the 34? As the price will often dip below a dynamic S/R and then reclaim it, some traders like to have a candle open and close completely under the chosen dynamic S/R before taking the loss. This is a very simple way of trading that is often called “one line trading,” and there is only one factor telling the trader when to exit: when the 34 is breached. If the price continues upward for long enough, of course, it is a sound idea to take profit when you are happy with the profits because there is always the possibility of being up huge on a trade and then ending up with a small gain. Those potential gains not being secured can have a large psychological effect on different traders. And everyone is different in this regard, so approach the take profit side of the equation carefully and honestly relevant to your particular trade tolerances and psychological makeup. A

And for the other side of it, when to take the loss…using a very simple dynamic S/R as an exit plan definitely keeps losses small (if they are followed religiously!).

The 34 EMA is only one example of dynamic S/R. But the core is the same. Regardless of what you use, S/R is dynamic if it is constantly sloping upward or downward. It can never be represented with a truly horizontal line because it is not static. Dynamic things change, and Dynamic support and resistance is ever changing as it responds to the price action of the security you are tracking.

 

VOLUME

Don’t forget volume in your S/R journey. You need to know the stocks you are trading. As part of that, you need to know what is considered the average daily volume of your tickers. Volume is an important part of S/R. If a support level is broken on the one minute chart, for example, but it is with low volume. It might be worth your while to delay closing your position on account of low volume. If it continues down and volume picks up, it might indeed be your exit ramp to get out with a small loss, lick your wounds, and regroup.

However, if an S/R is breached with significant volume it is likely the trend will continue, and you must factor that into your plan. Price action is heavily influenced by volume, so be aware of the volume situation as your trading day unfolds.

 

HOW NOT TO THINK OF S/R

Now that you have a basic understanding of what support and resistance is, it is equally important to be clear on what it is not.

What S/R is not, is a guaranteed area of expected price action reactivity.

This is a nuance that bears repeating. There are no guarantees in trading. Even the most experienced trading funds in the world using the most advanced technology and the very best data available to anyone often take losses.

While solid S/R skills can provide a good visual representation of probabilities regarding price action, it can never be considered a guarantee. The internet is full of horror stories of traders who lost big money and are perplexed because the price action didn’t do what they thought it should have done. Always be nimble, hyper-aware of all open positions you have, and keep up with your investments. One bad news item, one CEO scandal, or one geopolitical event is all it takes to see price action just knife through support after support. If the sentiment is negative (or positive) enough, S/R is not useful. Always be aware, nimble, and ready to kill any trades you may have open. And conversely, sometimes stocks will see big massive rises in price action just for a small amount of time during the day. If you have alerts set, you won’t miss these spikes if you might be approaching a personal exit goal. It is a sinking feeling to check in at the end of the day and see your retrospective chart provided you with a desirable exit that you didn’t take simply because you were unaware of it.

Always be learning more about support and resistance, always be willing to be wrong with your trade theses, always be informed, and always be watching!

 

TAKEAWAY

This article began with the claim that support and resistance belong firmly enshrined upon the Olympian throne of trading concept deities…and that remains the claim. The notion of where price action occurred with significant volume is a key level to understand when planning any trading thesis. As mentioned above, never take profits blindly with no overhead resistance anywhere to be seen. And, conversely, don’t lock in a loss if price action is descending down to a possible static or dynamic support level.

This all takes time in front of the screens, planning, executing, and reflecting on trades. However, with enough patience, discipline, practice, and data…you can learn to trade profitably. Support and resistance are the first of many concepts that you will have to master. Don’t delay; your future awaits!