Support and resistance levels are technical analysis tools that identify prices at which certain security faces a shift in supply and demand levels and they can be used to define potential entry and exit targets for a given trade.
Simply put, support levels are price points at which bulls will usually take over the price action, often because they see the security as ‘undervalued’ at that particular quotation.
Meanwhile, resistance levels are those at which bears either take over by short selling the instrument, or they might also be a price point at which bulls take some profits off the table from the latest uptrend in the security.
Learning how to identify key support and resistance areas in a price chart can allow traders to determine when to enter and exit positions based on the instrument’s historical patterns and although this is not a perfect science at all, these price levels have historically provided profitable signals when they are identified and used appropriately.
How to identify a support level in a chart?
Support areas are price levels from which a security has rebounded off multiple times, signaling that once the price reaches that point, bulls usually hop on the trade – which results in a short-term appreciation in the value of the instrument.
The US dollar index (DXY) hourly chart above provided by eToro shows an example of this, as the 90 level has served multiple times as a stronghold for the price action in the past few days. This chart is mostly relevant to day traders, as it illustrates the price trend in the very short term.
After identifying the $90 level as support for the US dollar index, traders can choose how they will tackle the trade since there are multiple options on the table in regards to how this information can be used.
Traditionally, support levels are used to take long positions once the price has bounced off that particular area, in anticipation of a short-term uptrend resulting from the move.
Using the chart above as an example, a trader could take a long position on the US dollar index once the price bounces of $90 – possibly at $90.25 to confirm that the bounce has happened – while a stop loss can be set at $89.75 to protect the portfolio from a break of the support line.
On the other hand, a day trader can also set a sell order to short the instrument if the price drops below $90, as a break of this nature would signal a shift in the market’s sentiment or it could also mean that the demand for the instrument has dried up and there are too many sellers and only a handful of buyers.
For that particular trade, a stop-loss order can be set above the $90 level, say at $90.25, as a move above that threshold again might signal that the previous break was just a false alarm or a move from sellers to trigger multiple stops – which can lead to a short-term spike in the price as ‘stopped’ traders will ultimately bid up the price if they want to get back to the trade.
Moreover, the Bitcoin (BTC/USD) chart above also shows a similar situation, where one can identify the $28,200 – $28,750 range as the area of support for BTC’s price action since the year started.
If the price were to move to those lows and bounce off them shortly thereafter, traders can take a long position based on the prospect that bulls will jump on board at that price as they might deem the coin as ‘undervalued’ at those levels.
Finally, there are multiple trading patterns that rely on support areas as a cornerstone. These include the head and shoulders and double-bottom formation.
How to identify resistance levels in a chart?
Resistance areas are those at which bears often taken over the price action or one that bulls are not yet resolved to overcome as they believe the instrument’s value is at its top once it reaches that threshold.
The chart above – which belongs to the German DAX index as shown by the eToro trading platform – shows that the market has responded negatively once the price has reached the 14,200 level, meaning that bulls either believe that such level is high enough for the DAX or that bears see a short-selling opportunity at that point.
On both occasions the price has responded dramatically, dropping from 14,200 to 13,600 which reinforces the thesis outlined above.
So, what can traders do once they have identified resistance areas for a particular instrument?
Similar to the approach taken once support levels are found, resistance areas can be used to take either long positions in an instrument – if the price suddenly breaks above that level, possibly marking the beginning of a fresh new uptrend – or to take a short position once the price has bounced off the resistance – which happened to the DAX index in the chart shown above.
It is important to note that support and resistance levels should only be considered as such if the price has bounce off them at least three or four times within a certain time frame.
This rule is an important one as a support or resistance area that has been tapped just twice might not be as strong as it should to hold when the next tap comes.
The more taps, the better, although that also counts for breaks. This means that if an area that has been tapped multiple times is breached, chances are that the market is ready for a brand new bullish or bearish phase – commonly known as price discovery.
Finally, through social trading platforms like eToro, traders can share their ideas about potential areas of support and resistance for multiple instruments to validate their analysis and hopefully make more informed trades.