How to Identify Support and Resistance Levels?
QUESTION:
I see that the lesson material within the FX Academy is heavily based upon identifying support and resistance. Can you explain how you identify support and resistance levels? Why do you rely so heavily on identifying support and resistance levels?
ANSWER:
Thanks for sending in a great question. You are right to say that our material is heavily based upon identifying support and resistance levels. This is because we believe there are really only two technical factors that can give retail traders a statistical winning edge. One is correctly identifying support and resistance, the other is trading with strong momentum.
I’ll explain how to identify good support and resistance levels.
A typical method is to look for sharp “V’ shaped price movements off a level that has not been touched for a while, and to expect it to hold again the next time it is touched. The problem with doing this is that it is really not precise enough. We need to find levels that have a higher probability of holding, and these levels tend to be areas that have just changed from support to resistance, or vice versa.
Such a level has to have gone through a three-stage process:
- Held as support or resistance,
- Was broken,
- Either has flipped to have held as the opposite without being broken yet, or be likely to do so the next time it is tested. Levels that are “likely” to do so are more risky but often produce a greater reward; I will talk more about these later.
Look for levels likely to act as the “pivotal points” that Jesse Livermore talked about in “Reminisces of a Stock Operator”.
To identify these levels, bring up a 4 hour time frame chart of the pair you are looking at and go through the following process:
Working from the right to the left, first look for an area that has held as obvious support or resistance. The sharper and more defined the price was rejecting, the better. Using a 4 hour chart of the GBP/USD pair as an example, here is what this first step looks like. I used blue lines to identify areas of possible support, and red lines to identify areas of possible resistance:
The red lines show levels above the current price that have held as resistance without yet being broken. The blue lines show levels below the current price that have held as support without yet being broken. I did not get all the way down to the bottom of the chart.
The next step is to look and find what happened the last time the price reached any of the identified levels from the other side, looking for stages 2 and 3 as mentioned before to have happened. Let’s take each level in turn, working from the top down:
a. 1.6436 is possible resistance. The last time the price was meaningfully above this level was last August, as we can see in the chart below:
Note how 1.6436 held as support for several days, as shown by the blue shaded area in the middle of the above image, before finally breaking down strongly. When the price returned to that level, shown at the blue shaded area towards the right half of the above image, it then held as resistance.
b. 1.6401 is possible resistance. However we can see that only a few hours before it was recently established as a level, it was failing to provide any support at the areas highlighted in blue in the image below:
Therefore we can forget about 1.6401 and move down to the next level.
c. 1.6290 is possible support. However we can see that a few days before it was recently established as a level, it was failing to provide any support at the area highlighted in blue in the image below:
Therefore we can forget about 1.6290 and move down to the next level.
d. 1.6256 is possible support. The last time the price was meaningfully below this level was last October, as we can see in the chart below:
Note how the level held as resistance almost to the pip, and then held again as price approached very close to it, as shown in the blue highlighted area. The level was later broken (not shown). Therefore we have a valid flip from resistance to support that has held, so we can keep this level as valid support.
Going back to the levels that have been broken but not yet tested, I will usually include these levels if they formed a strong and significant “V” shape peaking at the same level twice, and were then broken strongly with momentum. However I want to see them tested quickly. The longer they hold for, paradoxically, the more the market tends to forget about them.
A good example of such a level was shown previously at 1.6436. Even if this level had not previously acted as support, if it was broken strongly to the upside with momentum, I would mark it as likely support if the price would return to it quickly.
