Trader Tip: Support Resistance Identification Some traders have asked how best to identify support and resistance (S/R) lines and just how important are these S/R lines in technical analysis. For me, S/R lines are one of the first things I look at when looking at a chart. It shows the price points that buyers and sellers are willing to start and stop entering positions on an instrument. Understanding at what price these market players will act can be critical when trading.
Drawing S/R lines is a bit of an art. One can give the same chart to 5 traders and come up with 5 different S/R lines. That being said, if the quality of the S/R is clear, traders will have similar views of these S/R lines. In this Trader Tip we will examine the best ways to identify S/R lines (and their quality) to ensure consistency in this identification.
First, we should understand the psychology behind the principle of S/R lines. The best way to explain the principle is to think about your own feelings during an auction market to see this principle in play. For example, you would like to buy chairs. You first analyze the idea what you would have to pay – you may see several chairs go for an average price of $50. So you think that anything under $50 is a bargain and will start bidding more aggressively if price is significantly below $50 – once the $50 price is reached you back off the bid. This is the line of price resistance. Other players in the auction will notice the same thing. However, you begin to notice more people have come to the auction and the price starts getting ridiculous and gets bid up to $100. You notice that now with these new bidders the prices are always well over the $50 and if you really want a chair you will need to pay more. Once the price gets back or close to $50 you get excited and bid more aggressively because you now think you are getting a bargain, as the price gets closer to what you were originally willing to pay. This is a line of price support. What we have also just witnessed is the phenomenon of, once resistance is broken, it become support. The following are a more technical definition of S/R lines:
- Support is the price level at which demand is thought to be strong enough to prevent the price from declining further.
- Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further.
As discussed before, identifying S/R is not an exact science. Hence the following three points are critical in S/R identification and identifying the quality of the lines:
- The more touch points on an S/R line the stronger and higher quality the line is. Two touch points on an S/R line is weaker support than say 5 touch points.
- The higher the times-series chart that the S/R line occurs the stronger and higher quality the line is. For example, S/R lines of a 4hr chart are more valid than on a 15-minute chart.
- The longer the time frame in bars of a time-series, that the S/R line occurs the stronger and higher quality the line is. For example, a chart that touches three times the S/R line in the last 8 bars is weaker than one where it touches the S/R line in the last 40 bars.
It is this quality of the S/R line that creates the variability in traders to identify the S/R line properly. Obviously, the lower quality, the higher the risk. If you wait for a very high-quality S/R line, you will miss a lot of trading opportunities. This is something each trader needs to work out. One last note. Small volume spikes can confuse your view. A bit of an art, but often a crayon is better than a fine pen when identifying S/R lines. Check out below a video presentation of this Trader Tip post:
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