- The Footprint of the Money -
Chapter Two - Support & Resistance + Trendlines
Support and Resistance
Support and resistance is one of the most widely used concepts in trading. Strangely enough, everyone seems to have their own idea on how you should measure support and resistance.
Let’s just take a look at the basics first.
Look at the diagram above. As you can see, this zigzag pattern is making its way up (bull market). When the market moves up and then pulls back, the highest point reached before it pulled back is now resistance.
As the market continues up again, the lowest point reached before it started back is now support. In this way resistance and support are continually formed as the market oscillates over time. The reverse of course is true of the downtrend.
Plotting Support and Resistance
One thing to remember is that support and resistance levels are not exact numbers. Often times you will see a support or resistance level that appears broken, but soon after find out that the market was just testing it. With candlestick charts, these "tests" of support and resistance are usually represented by the candlestick shadows.
Notice how the shadows of the candles tested the 2500 resistance level. At those times it seemed like the market was "breaking" resistance. However, in hindsight we can see that the market was merely testing that level.
So how do we truly know if support or resistance is broken?
There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is not always the case. Let's take our same example from above and see what happened when the price actually closed past the 2500 resistance level.
In this case, the price had closed twice above the 2500 resistance level but both times ended up falling back down below it. If you had believed that these were real breakouts and bought this pair, you would've been seriously hurtin! Looking at the chart now, you can visually see and come to the conclusion that the resistance was not actually broken; and that it is still very much in tact and now even stronger.
So to help you filter out these false breakouts, you should think of support and resistance more of as "zones" rather than concrete numbers. One way to help you find these zones is to plot support and resistance on a line chart rather than a candlestick chart. The reason is that line charts only show you the closing price while candlesticks add the extreme highs and lows to the picture. These highs and lows can be misleading because often times they are just the "knee-jerk" reactions of the market. It's like when someone is doing something really strange, but when asked about it, they simply reply, "Sorry, it's just a reflex."
When plotting support and resistance, you don't want the reflexes of the market. You only want to plot its intentional movements.
Looking at the line chart, you want to plot your support and resistance lines around areas where you can see the price forming several peaks or valleys.
Other interesting tidbits about support and resistance:
1. When the market passes through resistance, that resistance now becomes support.
2. The more often price tests a level of resistance or support without breaking it the stronger the area of resistance or support is.
Trend Lines
Trend lines are probably the most common form of technical analysis used today. They are probably one of the most underutilized as well.
If drawn correctly, they can be as accurate as any other method. Unfortunately, most traders don't draw them correctly or they try to make the line fit the market instead of the other way around.
In their most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (valleys). In a downtrend, the trend line is drawn along the top of easily identifiable resistance areas (peaks).
Trendlines are an important tool in your toolbox as a Forex analyst and trader because they project price levels where the market is likely to bounce.
If you can draw trendlines correctly you will be able to define buy and sell zones and maximize your trading potential.
Both uptrends and downtrends can be defined by three primary trendlines: the inner trendline, the outer trendline, and the outer long-term trendline.
Finding your inner, outer, and long-term outer trendlines in an uptrend
An uptrend is a series of price swings where the market is making higher highs and higher lows. Just as there are trends inside of trends, there are price swings inside of swings.
An uptrend price swing starts at a low and ends at a high.
In any trend, there are three main trendlines: the inner line, the outer line, and the long term outer line.
To draw a trendline in an uptrend, draw across all levels of support.
If you have identified that the market is in an uptrend (the market is making higher highs and higher lows), you should draw all three of your trendlines before making a trade.
To draw the inner upward trendline, locate the last two levels of support (beginning from the current market price at the right of the chart) and draw your trendline between those two levels, extending it forward and up to the right.
Next, draw your outer upward trendline. First locate all your levels of support. Then, starting from the left side of the chart, draw your trendline between all the levels of support, extending the line forward and up to the right.
You will find that if when the market breaks the inner trendline, prices generally move to the outer trendline.
Drawing the Third Trendline
To find the third trendline, the long-term outer trendline, you will need to switch your chart to show a longer timeframe. For example, if you locate your inner and outer trendlines on a 60-minute chart, switch to a daily chart to locate your long-term outer trendline.
Once you are looking at a longer time frame, drawing your outer long-term trendline is the same as drawing the outer trendline: after locating all your levels of support, start from the left side of the chart and draw your trendline between all those levels, extending the line forward and up to the right.
Just as the market will likely move to the outer trendline if the inner trendline is broken, so will the market likely move to the long-term outer trendline if the outer trendline is broken.
The principle behind the three types of trendlines is this: there are trends inside of trends. The market moves in swings, which viewed over a long period of time are long and slow moving. But there are other swings that exist inside of those market swings, and they can be found within shorter time periods. For example, you will be able to identify price swings (trends) looking at a daily chart that are not very volatile (the swings are, once again, long and slow moving).
Looking at the same currency cross on a 60-minute chart you will see trends that are more volatile (the swings are shorter and move more quickly). The smaller your time frame, the more swings you will see.
Three trendlines help you see important support levels
Trading trendlines in an uptrend
To trade the inner upward trendline, buy when the market hits the inner upward trendline. Set your protective stop loss order (as always) at the last level of support. To trade the outer or long-term outer trendlines, buy when the market hits the outer upward (or outer long-term upward) trendline, setting a protective stop loss order at the last level of support.
You will sometimes see the inner and outer trendlines converging. This convergence is like a double or extra-strong signal, offering you two hints that the market will bounce. In this case, buy when the market hits the inner and/or outer trendline setting your protective stop loss order at the last level of support.