Asset prices are always evolving, making it absolutely essential to constantly be evaluating and reevaluating price behavior over time. One of the easiest ways to understand directional momentum and setup trades based on how an instrument is performing is by employing the most basic form of chart analysis: identifying support and resistance levels. Part of the bare bones basics of technical analysis, these crucial horizontal levels help to determine key levels where there is buying and selling pressure that can impact the directional momentum of an asset. Aside from helping to identify potential turning points, support and resistance levels are particularly helpful for setting trade entry points and exit strategies.
Price Ceilings & Floors
By definition, support and resistance levels are horizontal areas an asset’s price has difficulty falling below or rising above. In more generic terms, support acts as a price floor, or a level prices are unable to pass below. On the flip side, resistance acts as a price ceiling, preventing prices from rising above a certain level. Although these levels are not absolute, meaning that they do not hold fast all the time, they are very helpful in structuring trades because they help identify pockets of buying and selling that prevent prices from falling or rising.
However, support and resistance levels are more important than just defining points of buying pressure and selling pressure. These levels can also indicate when market sentiment is changing from bearish to bullish by suggesting when an asset has become undervalued or overvalued. At overvalued levels an instrument is likely to encounter selling while at undervalued levels the same instrument is likely to encounter buying.
Recognizing Support and Resistance
When it comes to identifying resistance, the key is looking for a key horizontal price level that an instrument has historically shown difficulty in overcoming. A strong indication that a level is acting as resistance comes after multiple tests, typically a minimum of three, of a particularly horizontal level on the upside. Even though prices may not touch the exact level every time, the general region is useful to identify. Additionally, candlesticks may break the level to the upside, but without a close above the level, the validity of resistance remains intact, and this may be viewed as a fake move higher intended to shakeout traders from positions.
For support, the reverse of resistance is true. When looking to mark valuable support levels on the downside, three points of contact is generally a good convention to utilize in order to validate the horizontal level. Similar to resistance, the level can only be considered broken when there is a candlestick close below prevailing support. If the candlestick fails to close below the level, support would still be considered intact.
Price momentum, mainly due to fundamental factors, can cause support and resistance levels to be broken. However, the story for these critical levels is not over once crossed to the upside and downside. It is essential to leave the levels untouched because they may in fact be relevant to price action down the road. Additionally, once broken, resistance will turn into support for further upside while support turns into resistance against upside. Although easy to dismiss these levels as irrelevant once broken, when identified correctly, horizontal levels can have significant value down the road for structuring trades.
As a reminder, it is important to recall that support and resistance levels are based on historical prices, volatility, and momentum. Past performance is not necessarily indicative of future performance for an asset. As such, it is important to remember that not every level will have the same amount of value in determining future price behavior. Although valuable to identify and maintain the levels over time, they should be viewed as guidelines and not absolutely reliable in all cases.