Have you ever entered a trade setup and wondered why price action almost immediately turned against your position?
Support and resistance (S&R) must've been the cause of this sudden reversal.
Today's article explains how to analyse and interpret the S&R within the market structure. It also reviews how to trade breakouts and reversals.
Price Reactions in the S&R Zone
Price action has to make a 'decision', or a reaction when it approaches support and resistance:
- The price can break below support or above resistance.
- The price can bounce at support or resistance:
- The price can show a mild bounce where the price goes sideways;
- The price can show a strong bounce where the price reverses.
Traders can judge which scenario is more likely by analysing the charts, and I will share my best guidelines for S&R analysis and trading.
Source: The EUR/USD weekly chart, June 2016 to July 2017, the green box indicates a bounce at support and the red box, a bearish break out after a consolidation (sideways move).
Breakout Vs. Reversal Calculation
The main equation I use is this:
- The force of price action versus the strength of the support or resistance zone.
The balance between the two factors will decide whether the price will break or bounce. Here is how the equation works out:
- Momentum (price action) is stronger than S&R zone → breakout.
- Momentum (price action) is weaker than S&R zone → bounce/reversal.
Hopefully, the 'formula' will help you assess the market structure with more clarity. Be aware that this is not an exact science, but rather a rough rule of thumb to assess the market.
In any case, you might be wondering how to measure both variables… A good question, which we will address in the next part.
Measuring the Strength of Support and Resistance
Let's start with measuring the strength of support and resistance (S&R). Here are, in my view, the two most important aspects when analysing the potential strength or weakness of the S&R:
- Points of confluence
- Time frames
Points of confluence: The more tools and indicators that align at a price zone, the stronger the support or resistance becomes. The strongest areas have at least three reasons that confirm an S&R zone. The S&R is usually weaker when only one or two reasons are present.
For instance, a support level is strong if the price approaches a 50% Fibonacci level, the round psychological of 1.10, a weekly Pivot Point, and the bottom of Admiral Keltner indicator.
Time frames: Support and resistance have more impact on higher time frames like daily, weekly, and monthly charts. Also, keep in mind that support and resistance is stronger when analysing it on one time frame higher than your entry chart. The S&R on the same or lower time frame than your entry is typically weaker.
Source: USD/JPY, 27 February to 4 July 2017, showing multiple reasons for a bounce at support such as Fibonacci levels, bottom, and Keltner indicator.
Momentum and the Number of Approaches
The other side of the equation reviews momentum and price action, which offers two critical insights:
- The presence or lack of quick price action (momentum);
- The number of approaches or attempts to break the S&R.
Momentum: Quick, impulsive price action is indicated by a few relatively large candles that mostly move in one direction and have candle closes around the candle high or low. Here is how momentum plays a role:
- When momentum is visible, the chance of price action breaking above the support or below the resistance level or zone increases.
- When momentum is NOT visible or price action is showing divergence patterns as well as weak or correction price action, the chance of price action breaking above the support or below the resistance level or zone decreases.
Number of approaches: The chance of a breakout varies depending on how often the price reaches the S&R zone. Here are the guidelines I use:
- First attempt: A bounce is more likely. On the average, the price tends to respect the S&R when it approaches the S&R zone for the very first time.
- Second attempt: Both a bounce and a breakout are equally likely.
- Third attempt or more: A breakout becomes more likely. A breakout starts to increase its chances when the price tests the S&R for the third or fourth time as the repeated pressure to push above the S&R indicates the strength of momentum.
Source: The AUD/USD daily chart, 27 February to 4 July 2017, showing a bounce at the green box despite a strong momentum as the price is approaching support for the first time, showing a breakout above resistance (red) on the right as the price is approaching the same zone for the second time, and the same trend line for the fourth time.
Letting Price Action Decide the Winner
The above-mentioned equation is therefore as follows:
- Power of momentum = speed of price action and number of approaches;
- Strength of S&R = points of confluence plus time frames.
The balance between both sides will indicate the likely winner but there is another key factor that plays a vital role:
- Candlesticks indicate how the markets actually react to the S&R zone.
Momentum vs S&R equation indicates whether a bounce or break is more likely, but the candlesticks provide key information about how the price is actually responding.
By analysing momentum, S&R, and market structure in general I am able to identify whether I prefer to trade in a bullish or bearish direction and whether I am interested in a breakout or bounce. In some cases, I could even be interested in both.
However, the candlesticks and the candlestick patterns at the S&R zone basically confirm or invalidate my analysis:
- With a confirmation, I have a potential entry;
- With an invalidation, I stay out of the trade setup.
Check the video below for more information on candlesticks.
For more articles, webinars, and information on trading, make sure to visit our main page at Admiral Markets.
Also, feel free to test Admiral Markets' MetaTrader 4 Supreme Edition – a special plug-in with 60+ extra features to tackle the markets including a package of extra indicators.
One of the best S&R indicators is actually part of MetaTrader 4 Supreme Edition: the Admiral Pivot Point indicator. It's a remarkable tool for spotting the S&R levels.
Cheers and safe trading,