Support/resistance trading

Introduction

The financial markets have been described by some to be random and that the price changes that occur are unpredictable while others believe that price can be less random and that there is some form of predictability in price which may offer an edge in the markets. The latter group known as technical traders believe that such movement occurs around certain high-value areas on the price chart and the resulting patterns that form around these areas, do offer the opportunity to position high-probability trades.

Support/Resistance

This can be defined as areas on the price charts that prices have reacted to significantly in the past and where buying (or selling) pressure may come in to push the price higher (or lower). These areas can be horizontal or diagonal (trend lines) and trades may be taken based on the price patterns that form around these. The most significant support and resistance zones are often those that are easily spotted on the chart (especially those on higher timeframes) and are obvious to all market participants. Example of this includes levels that have been tested several times, extremes of large spikes and visible highs and lows. Generally, the kind of trades that can be taken falls into two categories:

• Trend trading using pullbacks. Here, traders identify the value areas where a trend may retrace and would try to get in at the bottom of a pullback into the trend.
• Countertrend trading. Here, traders identify resistance or support zones where price movement may reverse in an overextended market.

So, traders using such a technique often use the following template:

• Identification of support/resistance zones and waiting for the price to approach the marked areas.
• Going long or short depending on price action in the zone.

Issues with support/resistance trading

Price action trading isn’t straightforward and some of the issues traders face when trading support/resistance areas includes:

• Identification of value areas: The challenge with the identification of areas especially for new traders is the issue of subjectivity. This arises because traders see differently even when looking at the same price chart and because it is possible to identify numerous potential support and resistance levels on the various timeframes, most of which are not significant levels that the market respects. This results in traders placing orders at the apparent levels while expecting the price to reject it.
• Trading bias: Most newbie traders often have a bias of how they expect the price to react as it approaches a level and bases their entire trading plan on that without considering what to do if the price reacts differently. This is the wrong way of trading support/resistance and would result in poor trading results. The better approach to trading around support/resistance zones is to wait patiently while the price patterns are formed and watch for confirmation before entering a trade. This approach is akin to reading the market tape and gives the trader an edge over a more impulsive trader.
• Traders expect the price to reverse off an area of resistance in the hope of entering a countertrend trade while neglecting the fact that trends only form by breaking through such zones. The reality is that a strong trend may keep making new highs while showing divergence on indicators such as the RSI or MACD. The majority of traders lose their accounts trying to short a trend they feel is overextended and has been showing signs of reversal (such as momentum divergence) but do so without waiting for confirmation via a break in market structure in a bid to get in at the very start of a potential reversal. One of the most important traits of a technical trader required for success is patience in waiting for confirmation before entering a trade.

Misconceptions about Support and Resistance

Some of the misconceptions traders have of support and resistance include:

• Support/resistance is a line: Some traders mistake drawing a line on their chart and expecting the price to react precisely at that level. Another example of this is traders placing orders at moving averages (which can be a form of support or resistance) and expecting the price to reject it. This idea is wrong and the correct way of doing this is to identify support and resistance as areas or zones on the chart and recognize that price may go lower in the zone before any potential rally.
• The more an area is tested, the stronger it is: Some traders believe that the more a support or resistance zone is tested and holds in the short term, the stronger it is. This is a misconception, and the reality is that true support or resistance area would show strong/instant rejection with only a few bars testing the area. This would mean that the more price lingers near any zone, retesting it multiple times, the weaker it becomes and the possibility of it being broken increases. Ideally, a strong support or resistance area shouldn’t be tested more than three times if it is to hold.
• Price always reacts at support or resistance on the chart: This is another misconception by traders who think that once a support zone for example has been identified on the chart, the price would bounce off it and retrace. Instead, support or resistance zones should be considered as areas of potential where price may react because the price may go through such zones without pausing or retracing.

Strategy Tweaks for Support and Resistance Trading: Countertrend

Countertrend trades are executed when a trend is overextended and prices appear to reject at previous highs (or lows) following a retracement. In the case of an uptrend, if the selling pressure at the previous high is large enough to create an imbalance, and the with-trend leg fails to make a new high, the price would fall and a potential downtrend may form. In countertrend trades, there are two potential entry points for traders:

1. At the previous high or low. With this entry, traders may establish new positions counter to the trend when prices approach the previous high after a retracement. If price movement stalls at the level, this results in the formation of patterns such as double tops (or bottoms in downtrends); head and shoulders. With price failing to break past the resistance level and signs of selling pressure coming into the market via candlestick formations such as a hammer or engulfing candlestick, coupled with other confluences such as divergence of an RSI indicator, traders may decide to enter a position. Stop levels may be placed at a reasonable distance above the previous high.
2. After a break in market structure. This is a more conservative entry technique where a trader may decide to wait for a break in market structure signalling a potential end to the trend. An example of this in an uptrend would be a break in the trend line or the formation of a lower low. Once this happens, the trader would wait for a pullback into the area and would place a trade if prices show rejection via a candlestick pattern showing selling pressure. Stops may be placed above the high of the pullback.

Of the above entries, I’ve found that waiting for a break in market structure is the best way of doing countertrend trades with a higher win rate and when combined with good risk management, would result in trading success.