The basics of support and resistance levels trading

The basics of support and resistance levels trading

This time, we will study the basics of support/resistance levels trading and find out, whether this strategy is close to “exchange grail”.

Only a lazy trader, after a couple of months of trading, doesn’t come across the notion of support/resistance levels in relation to the price move. On there Internet, there are numerous ads of levels trading strategies, “profitable levels trading”, “trade levels as a professional”, “super profitable strategy of levels trading”, and so on.

It’s the same on forums, it is fashionable to criticize different indicators and praise the analysis of levels in an empty chart. Those, who trade without indicators, look down on the traders, using them, because they “haven’t understood yet” and so, are far from professional approach to trading. But there is a mistake, which will be further described.

Based on my own experience of using horizontal levels in trading, I can disappoint those, who think this analyzing method to be something magical or superior to other strategies: levels don’t guarantee 100% profits. Any strongest level can be outbroken by the price. Even if all traders from your favorite forum and all the world analysts indicated the level as “very strong one”, the price can easily break through. Why?

Levels don’t guarantee 100% profits. Any strongest level can be easily outbroken by the price.

Let’s try to understand, what the support/resistance levels (or demand/supply zones) are in general, and how they are formed.

1.1 How the price is formed

Before you continue reading, try to answer the question: “Why the price goes up and down at all”? Don’t think about the price curve in the chart, recall the examples from real life. Remember, what is happening on sales or in times of product shortage. Remember?

Now, let’s study example №1:

There are three tomato sellers in the market.

The first one’s price for tomatoes is 50 per kilo

The second one’ s price for tomatoes is 60 per kilo

The third one’ s price for tomatoes is 70 per kilo

Who will you buy tomatoes from? Of course, from seller №1, as it is more advantageous for you. Will other people do so? I think, they will. Thus, we understand the law of supply and demand:“ the lower is a product price, the more is the desire to buy it”.

If we apply this law to exchange trading, we can say so: traders-buyers will compete with each other for the lowest price offered by traders-sellers.

And now in simple terms: if the price for i-phone X is drawn down, it will be bought by more people than now.

Traders-buyers will compete with each other for the lowest price offered by traders-sellers.

1.2 What moves the price?

Imagine, that you are a large player in the foreign exchange market, Forex. Not the one, who is a “market maker” and thought to cause other traders’ losses without losing himself/herself. Just a large market player. A fund, for example. You need to buy a lot of euro, 5 billion, for example.

Price	Amount for this price
1.1600 $	2 billion EUR
1.1500 $	2 billion EUR
1.1400 $	2 billion EUR

According to the law of supply and demand, and common sense, as well, you will start to buy for the lowest price offered, for 1.1400. However, we see, that the amount of euro is not sufficient, the seller offers 2 billion, but you need 5 billion. After your deal with the seller, he/she joyfully exits the market, and you are left with the need to buy 3 billion more.

What happened?

The lowest price for euro, before you had entered the market, was 1.1400. When you started buying it out, you bought all the amount for this price (2 billion). Now the lowest price for euro in the market is 1.1500. So, because the amount of your purchase exceeded the amount of sales for the price of 1.1400, the price rose up to 1.1500. How long will the price grow? Until the amount of purchases exceeds the sales amount.

In your example, you will buy out all the amount for 1.1500 (2 billion) and a half of the amount for 1.1600 (1 billion). Thus, while you are buying 5 billion euro, the price will have risen from 1.1400 up to 1.1600.

What conclusion can be drawn?

Price rises until the amount bought is more than the amount sold. So, as soon as more is sold than bought, the price will fall down.

The price will rise until the amount of purchases exceeds the amount of sales.

1.3 What can stop the price?

And, finally, we have come to the most important point, what will happen if you want to buy your 5 billion euro for a certain price, and strongly object to buying for a higher price? Let’s study the previous example, but change the values:

1.1600 – 2 billion EUR
1.1500 – 2 billion EUR
1.1400 – 2 billion EUR

You buy 2 billion euro for 1.140, and need 3 billion more to buy. Suddenly, a more active but as large as you player goes ahead and starts buying out euro for 1.1500, then for 1.1600, for 1.1700, and so on (remember the example with iphone), due to this, the price is surging very fast. That’s all. The price has grown up, and you don’t want to pay more, so you are just waiting until there is the price, you need. If the price goes back down to 1.1400, you will resume buying. If you want to buy more euro, than is offered for 1.1400, you will again stop the price falling down and can trigger its growth. How it will look in the chart? That’s about how it will:

support level 1.1400

That is, there, where you buy out all the sales, will be large price swings: the price is going down – you buy out all the supply – other traders see this stop and start to buy, thus pushing the price up.

And exactly those price swings are the popular support and resistance levels.

The prices, for which large amounts are bought, will swing greatly. Exactly those swings are taken to build support and resistance levels.

1.4 The great secret of support and resistance levels

Have you already understood, what I am driving at? I mean, that these levels, as any information, any method of analysis, any indicator, are based on the previous price moves. Even if you analyze just price, you are already behind and analyze the past events. And support and resistance levels, in this respect, are a usual, unremarkable method of analysis, which is neither better, nor worse than any other. In my opinion, it is a bit more accurate than Fibonacci levels or Elliot waves, there can’t be many variations of these levels, so it provides more precise information for us to make a decision. There is always an uncertainty in price further movement and the risk of a losing trade.

The levels, in their essence, are nothing but price ranges, which were (not are!) attractive for large purchases and sales. No guru trader can know in advance, whether the interest in a certain price range will remain in future, or it will be forgotten.

To sum up, I want to note, that I, myself started from indicator strategy and have tried quite a lot of ways of analysis. And it also seemed to me for some time, that the levels are the best, the most accurate way to analyze the chart. However, having studied the essence of the market processes deeper, I understood, that the price can be analyzed in any way. There is no unique method, there wasn’t any and will never be, traders should use the strategies, they understand and like more.

Support and resistance levels are nothing but price ranges, which were (not are!) attractive for large purchases and sales. No guru trader can know in advance, whether the interest in a certain price range will remain in future, or it will be given up.

I chose the levels, because they are simple. They help to understand current price moves, identifying good zones to open a position, set stop-loss orders and finding out a position’s prospects. However, they don’t and can’t have any additional advantages over other trading techniques, no one can know in advance, how the price will respond to an identified support/resistance level.

I’ll also add, that, although the method is rather simple, you’ll need some time to learn to apply it practically. There are no exact parameters to understand, whether the levels are built correctly or not. So, one can answer the question, “how to build support/resistance levels correctly”, only having spent a long time on practical use of the method in Forex trading.

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