Support and resistance levels are widely used technical tools and form the basis of most chart patterns. When we mention the support area in trading any market, we understand it as the price at which buyers are expected to enter the market in sufficient numbers to stop its price from falling further. And we say that resistance is the level at which sellers enter the market in sufficient numbers and prevent the market from moving prices upward.
The ability to identify levels of support and resistance in a chart can also coincide with a good entry or exit price for a specific trade, as market participants see good values to enter or exit a position. It also acts as an alert to look for changes in demand and supply, as breaking below support indicates that there is excess supply, and this will bring prices lower and vice versa, a resistance breakout signals that demand is above supply, which should press the price higher.
Many times, when prices make a new low, buyers who missed those lows on the first time will be tempted to enter their buy orders once this low is tested for a second time. As they enter their long positions in considerable volumes forcing prices to move upward, the resulting upward move reinforces the importance of that price level and a support level is created on the chart.
The same logic holds true on the upside. When a market makes a new high, sellers who missed those highs on the first move will be tempted to enter their sell orders once this high is reached for a second time. As they enter their sell orders in considerable volume forcing prices to retreat, the resulting correction reinforces the importance of that price level and a resistance level is created on the chart.
Resistance areas, when penetrated, become support and vice versa. The logic behind this is that sellers or buyers who sold or buy near resistance and support areas and see prices trading above or below their entry price will likely buy back or sell back once prices get near their break even point.
The importance of a support or resistance area increases in significance by the number of times that the level has been tested and by the volume traded at that price.
Support and resistance level are useful on any time frame and in any market. But how are support and resistance calculated? How can I use it for my trading decisions?
There are many formulas to calculate support, pivot and resistance. The most common is the classic formula or “Floor Trader pivot points,” and you can easily get your numbers for any market or stock by following this formula using the previous day’s (or period’s) high (H), low (L) and close (C):
Pivot (P) = (H + L + C) ÷3
Resistance (R1) = (2 X P) – L
R2 = P + H - L
R3 = H + 2 X (P - L)
Support (S1) = (2 X P) - High
S2 = P - H + L
S3 = L - 2 X (H - P)
When you have decided which market you want to trade you can start by choosing a time frame and calculate your points. After that, drawing the lines in your chart as a visual guide will help you to see how prices react to the support, resistance and pivot levels.
These lines will help you: Go long when the price has reached support; go short when the price has reached resistance; buy breaks when the price trades above resistance and sell breaks when the price trades bellow support.
You can also place stop-loss orders below the support or above the resistance area where you bought or sold. That sets up a very low risk trading opportunity.
The lines also allow you to set profit objectives. As prices react to these numbers, they will help you to hold a winning trade until the next level and take profits at the right time.
In “Using the lines,” you can see how decisions can be taken using support and resistance. A successful short trade could have been initiated using the major resistance line. Each line represents an objective and once an objective has been reached, that level moves from support to resistance and becomes a profit taking target. The second test of major support presents a solid buying opportunity.
As you can see the benefits of using support, resistance and pivot points are enormous and can help you to develop a better trading strategy.
Arturo Stern is a market analyst for equity index futures and the author of the "Daily Trading Advisory" newsletter and other advisory tools for stock index futures traders. E-mail him at email@example.com or visit his website at www.TheMiniTrade.com.