How to use support and resistance levels in trading

One enduring feature of market analysis is the imposition of lines on charts. Two popular ones are support and resistance trendlines. But how useful are these trendlines? Do they really improve our market analysis and trading success?

To answer these questions, we first need to know what support and resistance are. Consider this price sequence:

20—50—20—50—20—50

Immediately, you can see that the support is at 20 and the resistance at 50. In other words, a support is an area of demand, whilst a resistance is an area of supply. Logically, prices fall from resistance; and rise from support.

In actual financial markets, however, randomness pervades. This means that prices are more likely to look like:

21—52—23—46—26—44

Where are the support and resistance (S/R) now? Far harder to know. The resistance could be 50, 48 or 45.

Our next question, then, is this: Which sequence would you bet? I suspect the first one. Why? Because it offers relatively more ‘certainty’ due to its better defined price pattern. This certainty gives you, as an investor, more confident that prices will continue to behave 20—50—20—50…

Therefore, just with these simple observations we note:

Observation 1 – S/R trendlines are one way to see ‘patterns’ in financial prices. Nothing more, nothing less. Trade management still counts.

Observation 2 – S/R trendlines are ‘self-reinforcing’, meaning that the more people look at it, the more significant it will be. And the better defined the chart patterns are, the more people will look at it. So pick the most obvious ones.

Observation 3 – Peaks and troughs are seldom ‘exact’. Prices don’t peak at 7000.00 but at 7012.15. So when drawing S/R, remember to give prices room to move. ‘Trend bands’ are slightly better than trendlines.

Application – FTSE 100 Index

To tie these observations into chart analysis, we look at the UK FTSE 100 Index.

During 1998-2018, where do you think was the obvious resistance level? 7,000 of course. Thrice the index rallied to this level and failed twice to break above this level. And support? Hmmm, I would pick 3,500 – a level reaffirmed twice, in 2003 and 2008. But on recent data, 5,000 or 6,000 are two candidates.

Without going into a deep analysis on Footsie’s valuation or UK’s macro performance, which directional bias is the FTSE 100 on: Up or down? Certainly up. This is because prices are closer to its long-term resistance than support.

Note further that, in late 2016 when Footsie cleared the 7,000 resistance, this made headlines (eg, ’FTSE in Uncharted Territory’) and drew in many momentum buyers. The breakout at 7,000 gave way to a year-long, 800-point rally. This leads us to the next two S/R observations:

Observation 4 – S/R trendlines that coincide at big round number levels attract the most attention.

Observation 5 – A break of these levels generates price momentum in the direction of the breakout. So join the crowd.

Conclusion

S/R are useful charting tools to analyse markets. But they are not everyone’s cup of tea. If you are keen on them, do keep in mind the above observations and make S/R trendlines really simple. In my experience, over-complicated trendlines often lead to ‘analysis paralysis’, which is detrimental to investment success. A consistent, logical application of long-term S/R trendlines will make your analysis far more efficient – and makes you better attune to the prevailing trends.

Ten things to understand before you start trading…

1.    How to use support and resistance levels in trading
2.   Using Moving Averages Effectively – Part 1
2.5 Using Moving Averages Effectively – Part 2
3.   Momentum indicators and trends change
4.   Understanding Price Breakouts and its Significance
5.   Q&A On Price Patterns With Jackson Wong PhD
6.   The Importance of Group Analysis
7.   Three Chart Characteristics That Precede A Trend Change
8.   Thoughts on trading the market via Breadth
9.   Six Market Trends To Look For Outside Individual Price Action
10. The Key To Long-Term Investment Success – Know Yourself…

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