Understanding the Supports/Resistances Indicator
Supports/Resistances indicator (S/R indicator) is one of the main technical indicators used by traders because of its importance regarding market psychology and supply/demand. We should think of supports as a floor and resistances as a ceiling, with prices moving up and down between them. Understanding how the S/R indicator works is fundamental to predict where a trend is going. By knowing if a trend is likely to reverse or to breakout, a trader can choose whether to open a long or short position.
Supports are seen as the level at which traders are likely to buy the stock, therefore moving it upwards. On the other side, resistances are seen as the level at which the stock is likely to go downwards as a lot of traders may sell it. In this sense, resistance is represented by a horizontal line connecting several tops while supports are represented as a horizontal line connecting several bottoms.
Very often we observe that these Supports/Resistances are defined to be an area instead of a line. These areas are called congestion areas.
How does it work
Traders are more prompt to buy or sell at some levels, taking into consideration where the previous trend peaked or bottomed. Some psychological levels, usually round numbers, like 100, can also affect their behavior.
To exemplify the psychology of traders, let’s suppose a trader who bought EUR/USD at around 1.10. Right after buying, the EUR started moving down. This trader sees the price bottoming down and bouncing back. In order not to lose money on the trade, he agrees that he will likely get out if the price goes to the value where he first bought it. If a lot of traders think in the same way, we will observe that the trend will reverse each time it reaches the 1,10 level, creating a resistance. The inverse works out if we are talking about a support.
The strength of a resistance or a support is positively correlated to the number of times prices touched the level and rebounded. If a trend touches a resistance or a support for several times and reverses, this resistance/support can be considered stronger than one tested only once or twice. If supports/resistances are consistently tested and prices consistently bounce back, that shows signs of a great commitment by traders to this price levels.
In sum, we can say that the supports/resistances indicator depends mostly on its length and volume of trading. The longer a support or resistance remains unbreached, the stronger it is. The higher the volume of trading at this S/R levels, the stronger it is, as there are more traders thinking in the same way, causing a reversion of the trend.
Why do traders use this indicator?
The price action and volumes analysis help to understand if the S/R line is likely to be broken and a breakout will occur. The profit from opening a position on a breakout signal may seem great, as the bullish or bearish sentiment becomes stronger, driving the price up or down with much more confidence. However, false breakout signals are more likely to happen than actual breakouts, which may catch some traders off guard. Hence, it is very important to look at the major trend. If you’re looking at 1H chart and see the price approaching a resistance, check the 4H or even the daily chart to see where the major trend is going. If it is going upwards, and there is an upside breakout, this is most likely to be confirmed and the odds are that the trend will not pullback into the congestion zone.
Once there was a real breakout and prices are moving in the trend direction, the level that was once a resistance is now considered to be a support, while the level that was a support starts to act like a resistance.
The market moves in small trends that go sideways the majority of the time. As such, it is important to establish some techniques in order to be able to profit from this moves. This means that the S/R indicator is highly effective when we observe a market that is moving sideways between supports and resistances. The trader should apply a reversion strategy and sell when the price touches a resistance (or buy when it approaches a support) if he expects a reversion of the trend. On the other hand, if he is able to spot a possible successful breakout, he should open a long position right after the occurrence, in the direction of the trend.
Download a Supports/Resistances Indicator for Metatrader 4 HERE