Understanding Support And Resistance Levels

One of the first things you have to learn as a price action trader is the concept of support and resistance levels. Support and resistance levels are points in the market where the price has a high probability of reversing. Knowing where these levels form and the reason why they form, can help you in predicting when the price is likely to reverse and start moving in the opposite direction. Today’s article is going to be a small introduction into the concept of support and resistance levels for beginner price action traders. I’m going to walk you through what causes the levels to form, show you how they work, and give you some examples of potential trades you could have taken at support and resistance levels.

Below is a list of some of the main things you can expect to learn by the end of today’s article:

  • What Are Support And Resistance ?
  • What Do Support And Resistance Levels Do ?
  • How To Trade Support And Resistance Levels

What Are Support And Resistance Levels ?

Support and resistance levels (or support and resistance lines as they’re often called in price action books), are basically points in the market where the price has a high probability of reversing and moving in the opposite direction. They are drawn on the chart using horizontal lines, and are found by looking for the times when multiple reversals occurred from similar points to one another.

image of support and resistance levels on eur/usd Here’s an image of some support and resistance levels which formed on the 1 hour chart of EUR/USD.

In total you can see there are six levels on this chart. Three support levels and three resistance levels. Each of these levels have caused multiple reversals to take place in the past, which confirms that they are in fact support and resistance levels which have a good chance of causing more reversals to take place in the future.

Support and resistance levels get their name from what they’re expected to cause the market to do upon being reached. Support levels are supposed to support the market and stop it from moving lower, whilst resistance levels are supposed to stop the market from moving higher, thus causing it to resist higher prices. Because support and resistance levels cause the market to do different things, it means they always form either above or below the current market price.

  • Support levels always form BELOW the current market price, and are points where the market has a higher probability of reversing back to the upside.
  • Resistance Levels always form ABOVE the current market price and have a good chance of causing a reversal to the downside.

Lets take a look at some images of support and resistance levels, so you can see how they form in relation to the current market price.

image of support levels on usd/jpy In this image you can see three support levels which I’ve drawn on the 1 hour chart of USD/JPY.

We know these are definitely support and resistance levels due to the fact multiple reversals, (marked with X’s) have taken place from similar prices to one another, and we know these levels in particular are support levels because they are all found below the current market price.

image of resistance levels on usd/jpy Here are five resistance levels which formed on AUD/USD.

Again we know for sure that these levels are actually support and resistance levels because they all caused multiple reversals to take place, and we know that they are specifically resistance levels due to the way they are all found above the current market price.

Hopefully that’s given you decent little overview of what support and resistance levels are and what they are supposed to cause the market to do upon their formation.

Lets move on now and take a look at what actually causes support and resistance levels to form in the market.

 

What Causes Support And Resistance Levels To Form ?

Most price action traders believe the reason support and resistance levels form, is because of traders repeatedly placing trades to stop the market from breaching past a price which they deem to be significant. The reason why they don’t want the market to break past this price is never known, nor is the exact price they want to stop the market from breaking, because each time the traders come into the market and place trades to stop the price from being broken, the resulting up or down movement always originates from a different price.

Even though what I’ve explained above is the reason most traders believe support and resistance levels form in the market, it’s not actually true, as I’ll now explain.

The reality is support and resistance levels are not created by traders placing trades to stop the market from breaking beyond a certain price, they’re created by traders putting their stop loss and take profit orders at round number prices, prices in the market which end with either 00 or 000. When the market reaches one of these prices the bank traders tend to enter trades or take profits (as these both require there to be orders present), which causes the price to reverse and start moving in the opposite direction.

No one knows exactly why stop loss and take profit orders build up at round number prices. One theory is that people have a psychological bias to place orders at numbers which they see as being more prominent than others. In the forex market, round numbers (i.e numbers which end with oo or ooo) are viewed as being prominent, so traders tend to place their stop loss and take profit orders there without really understanding why they place them there in the first place. (Due to the bias not being known to the traders themselves)

This theory hasn’t been confirmed yet, but it is one of many which exist about why orders cluster on and around round number prices.

image of support and resistance levels on eur/usdHere’s an image of some support and resistance levels I marked on the 1 hour chart of EUR/USD.

When the market returns to one of these levels you’d be expecting it to reverse, because of the fact it has reversed multiple times from these prices in the recent past. If it’s reversed multiple times before, it means traders must often use the round numbers which these levels have been placed on as places to put their stop loss and take profit orders.

If the market come close to the levels in the future, they’re likely to place their orders at the round numbers again, which means the banks will cause the market to spike into the level so they can get their own trades placed or take profits off any existing trades they already have open. When they complete one of these actions the market will reverse and start to move away from the level.

 

How To Trade Support And Resistance Levels

Support and resistance levels can be traded in a huge number of different ways, but the easiest and most common method of trading them involves watching for price action patterns, such as pin bars and engulfing candles to form when the market reaches a level. When a pattern forms it’s a good sign the bank traders have decided to get trades placed or take profits using the orders which had been placed at the level by the traders in the market, meaning it’s likely you’ll see the market now reverse and begin moving in the opposite direction.

Of course the appearance of a price action pattern at a support or resistance level does not always guarantee the market is going to reverse. Often you’ll see a pattern from but the market will just continue to move through the level without any kind of reversal taking place. Unfortunately it’s very difficult to know beforehand when a pattern is going to cause a successful reversal to take place and when it’s going to fail.

Overtime, as you become more experienced in watching the price action form around support and resistance levels you’ll be able to get a sense of when a pattern is going to fail and when it’s going to work. This will help you become more profitable trading support and resistance levels but you’ll still end up having your fair share of losing trades due to pattern failures.

 

Examples Of Trades Taken At Support And Resistance Levels

With that out of the way, I think it’s time I showed you some examples of potential trades taken from support and resistance levels, so you can understand what to look for when you see the market return to a level you’ve drawn on your charts. I want to make it clear that the following examples aren’t trades which I’ve actually taken, they’re just examples to show you how the different price action patterns should form at the levels.

image of bullish pin bar at support levelHere’s an example of a bullish pin bar which formed at a support level on the 1 hour chart of EUR/USD.

You can see how the bullish pin bar formed after the market had spiked through the support level which had been marked on top of the 1.06000 round number. This support level had caused five recent reversals to take place by the time the market dropped down and created the bullish pin bar. When the market moved up through the level (marked in blue) a large number of typical forex traders would have entered long trades, under the impression the market is probably going to continue moving higher.

Their stop losses on these buy trades would have been placed at the nearest round numbers the market broke through during the move up marked in blue. The 1.06000 number which I marked as a support level was the price at which the majority of their stop orders were placed (as evidenced by the fact the market reversed shortly after hitting the level), whilst the 1.06100 round number was also a price where some of the traders had placed their stop losses, but not many when compared to what had been placed at the 1.06000 level.

When the market drops and gets close to the 1.06100 level, a small up-move occurs. This is because the majority of the stop loss orders at this level had not all been placed exactly at the round number itself. Most had been placed slightly above because traders are frequently taught not to put their stop losses right at support and resistance levels or round number prices, due to them being a target for the bank traders. So although the market didn’t actually hit the 1.06100 level, it was still the level which caused this small up-move to take place.

Ultimately the up-move comes to an end and the market drops again. When it drops this time it falls through the 1.06000 round number which I’ve marked as a support level. The number of stop loss orders placed at this level were much higher than the stops placed at the 1.06100 level, which is why the bank traders decided to get some of their own buy trades placed here instead of at the 1.06100 level.

When they place their trades it causes the price to rise and creates the bullish pin bar we see at the support level. This would be the time we enter our own buy trades, because the formation of the pin bar at the support level is a strong sign the market is going to reverse.

Let’s take a look an example of a bearish pin bar forming at a resistance level

image of bearish pin bar at resistance level In this image you can see an example of a bearish pin bar which formed after the market encountered a resistance level on the 1 hour chart of USD/JPY.

The resistance level was found at the 105.100 round number. Multiple reversals had taken place from around this price in the past, including two which had formed recently (marked with X’s). As the market approached the resistance level you can see a small drop took place just above the tick I’ve marked. This drop would’ve made quite a large percentage of traders enter short trades, because during the time it was taking place, it looked as though the price was going to continue falling. When the traders enter their short trades they go and place their stop losses around the nearest round number where they’ve placed them before, which in this example is the 105.100 resistance level.

The bank traders can see that a large number of stop orders have built up around the 105.100 level, and decide to cause the market to spike through them in order to get a large portion of their own sell trades placed. Unlike the previous example the spike through the round number we see here does not stop just after the 105.100 resistance level is broken. Instead we see it continue until it has spiked just beyond the 105.200 round number seen above. It’s likely some additional stop loss orders had been placed here, which the bank traders decided to make the market hit to get more of their own sell trades placed into the market.

When the market has spiked just above the 105.100 round number the banks place their remaining sell trades and the price falls, creating the bearish pin bar we can use to enter our own sell trade at the resistance level.

Now lets see some engulfing candles forming at levels of support and resistance.

image of bullish engulfing candle at support level The image above shows a bullish engulfing candle which caused the market to reverse after forming at a support level on EUR/USD.

This engulfing candle formed after the market had already ran into the stop losses which had been placed at the 1.05000 round number support level. The traders had placed their stops at the level after seeing the market move up slightly three hours before the bullish engulf formed. Similar to the small move down we’ve just looked at in the bearish pin bar example, the small up-move we see here (marked in blue) causes people to think the market is reversing. In an effort to make money from what they believe to be a reversal, the traders decided to place long trades with their stops placed at the 1.05000 round number.

Like before, the banks decide to make the market hit the stops so they can get their own buy trades placed to cause the market to reverse. When the stops have all been hit, the banks enter their buy trades and the market rises, creating the bullish engulfing candle at the support level. The bullish engulf adds further confirmation a reversal away from the support level is going to take place, so your own buy trade, if you decided to trade this reversal, would be placed after seeing this engulf form.

image of bearish engulfing candle at resistance level Here you can see an image of a bearish engulfing candle which formed after the market had spiked through a resistance level on AUD/USD.

The bearish engulf in this example did not form on the resistance level itself, like the engulf on the support level did in the previous example, it formed after the spike had occurred and the stop loss orders had already been hit. The stops themselves had been placed at the 0.77400 level after traders thought that the two down-moves marked in blue were the beginning of large reversals taking place. The banks noticed the accumulation of stop orders and made the decision to cause the market to move into them as a means of getting more sell trades placed into the market.

When the market hits the resistance level where the stops have built up, the banks place their sell trades and the price drops, first creating the wick on the bullish candle which pushed the market into the resistance, and then the bearish engulfing candle which formed an hour later. If you wanted to trade this reversals you would enter your trade after the bearish engulf has formed, because it’s formation is a sign the bank traders have got sell trades placed and want the market to reverse.

 

Summary

Hopefully you now have a much better understanding of the core concepts surrounding support and resistance levels. Although there is still much more to learn about the levels, I think what I’ve given you here today should be enough information to get you interested in using them in your analysis of the market.

If you look below you’ll see I’ve left some links to the other support and resistance articles I have on the site. Check out these articles if you want to learn more about support and resistance levels. I especially recommend you read the “How To Easily Draw Support And Resistance Lines” article if you plan on using support and resistance levels in your day to day trading.

Thanks for reading, please leave any questions in the comment section below

Resources

Here’s the links to the other support and resistance articles:

How To Easily Draw Support And Resistance Lines

A Simple Support And Resistance Indicator You Can Use On MT4

Two Simple Support And Resistance Trading Strategies

Combining Support And Resistance Levels With Supply And Demand Zones

Two Places You Can Find Key Support And Resistance Levels

4 Comments

  1. stephen James
  2. Alan Murrell
  3. Becks
    • ForexMentorOnline

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