Whatever the entry system is for your trading strategy, knowing where simple support and resistance levels are can increase your chances of trading success. If for example, you were to get a setup to go short just above a previous level of support, there’s going to be an elevated chance of some sort of bounce – and if that bounce is large enough relative to your stop, you’ll have to take a loss before seeing whether the market can push through the level.
But many people still don’t recognize what a decent level looks like on a chart and commonly they try to draw in a level where really they shouldn’t. In the post Oh Lord, Why Are Market Price Levels So Misunderstood? I talk a bit about what levels are conceptually, but here I want to outline how to identify simple, usable structural price levels.
Identifying simple support and resistance levels
There are a few key aspects to identifying simple support and resistance levels that over time, have become second nature to me. However, it takes a bit of practice to be able to quickly and accurately assess all the information that’s in front of you in order to weigh the likely importance of a level. Here’s a list of some of the factors that I believe make up a level – and you can use these in your trading straight away.
First of all for simplicity, I’m going to specify that we’ll only be looking at “naked” levels. These are price levels that have not been retested since the swing high or low was put in. The reason for this is that the first time the market revisits a level, it’s more likely to get a reaction.
The size of a swing into and away from a level is crucial. If it’s too small, the level isn’t going to be one where a significant amount of trading activity has come in and reversed a move – and the kind of activity we’re trying to identify is where it’s significant enough to motivate traders again. What constitutes a good size of swing will depend on the specific product you are trading and current volatility.
The way a level is formed can make a real difference too. Is it sharp or blunt in shape? How quickly did it turn from the price and how much activity in terms of volume traded/number of trades took place at the area of the reversal. Type of swing coupled with swing size, can help to assess the strength of trading activity and importance of a level going forward.
Proximity to other levels
Where support and resistance levels sit relative to other levels can make a real difference too. A level might be less valid if it is very close to another without exceeding it, even if it’s a clear swing in its own right. So it’s important to compare extremes to other recent highs/lows from chart timeframes no smaller than those you use to trade – e.g. on a 15min chart, daily highs/lows, weekly chart etc. If a swing stands out on its own in a period, the chances are that it’ll be watched by a good number of traders when it gets there again.
Strength through confluence
The more references a market has at or close to a price level, the greater the number of traders who will be looking at the price and therefore the more likely it is to generate interest – whether that interest precipitates a reversal or the level breaks and a continuation move takes place. If there are more reasons to take a trade, there will be more traders who will do so. So if you have nice swing high from a few days ago and that lines up a particular moving average or whatever else you might look at, then the level is likely to be more important.
If the level also fits in with market context and/or a price pattern such as what I describe in When do Candlestick Patterns Really Work?, then this can really solidify the importance of a price level.
Reactions to a level
Finding decent support and resistance levels is just part of the puzzle. Accounting for possible reactions to a level is just as important. There are two market reactions that can happen at any price level – it can turn or it can break.
If it turns, it can turn quickly and sharply – this is when a poorly placed trade can be quickly stopped out – or it can churn at the area for a time before reversing – if this happens, you can see the market test and retest the level and it may push through by a number of ticks before turning. So this makes it important to consider how many ticks beyond a level that an entry or stop needs to be in order to not be tagged without the level having truly broken – and this will depend on the product and current volatility.
If it breaks, the break can happen immediately – if this happens, you frequently see a retest of the level from the opposite side – or it can back off the price on the first test – this is one of the reasons why taking an initial scale out can be such an effective money management technique.
Do your daily preparation
Assessing chart support and resistance levels does not need to be difficult once you get the hang of it. But once you have, not doing your daily preparation to identify them is just plain daft. It’s also the reason why many traders look back at a chart after having taken a losing trade at a poor location and feel silly because they’ve missed an obvious level. Don’t be that trader – do your daily preparation.
Recognition of what decent support and resistance levels look like and routinely doing daily preparation that includes marking up on your charts even a very basic identification of these levels, can help you to work within the market’s own framework regardless of the type of strategy that you trade. With a bit of practice, you’ll find that at the very minimum, it helps you to avoid taking trades into areas where strong trading activity reverses the market and stops you out of you position.
For more updates from Mark and the team at NetPicks, be sure to visit their trading tips blog at NetPicks.com.