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The Importance of Support and Resistance Levels

When it comes to the financial markets, detecting the key support and resistance levels becomes decisive for developing trading strategies, including candlestick and chart patterns, technical indicators, etc.

 

Understanding Support and Resistance Levels


Support and resistance levels are the most practical notions in technical analysis. These focal price levels specify the supply and demand forces in the market. Technically speaking, the dynamic forces of supply and demand are the key reason behind each price movement.

Once demand takes over supply, it could result in a price appreciation. On the contrary, when supply surpasses demand, a price drop happens. However, in the case of the equilibrium between the forces of supply and demand, the price is expected to move sideways, signifying a consolidation/range stage in the market.



Support levels reveal prevailing demand in the market, where the buying pressure is more aggressive than the selling pressure, holding the price from further drops. On the other hand, resistance levels indicate the dominance of supply, where the selling pressure is high and overwhelms the buying pressure, halting upward price movements.

 

Support and Resistance Levels in Trading


Identifying the key support and resistance levels ought to be the initial step of any trading strategy. These price levels assist traders in recognizing possible entry and exit levels, foretelling the potential reversal points, and can be used as a confirmation for other price action patterns and technical indicators.

Hence, being aware of the major support and resistance levels before making trading decisions help traders gain insight into the imminent price direction and validate other signals indicating their entry-level.

Keep in mind that supports and resistances aren’t actually an exact price level but also specify a price region/range serving support or resistance to the price.



It is worth noting that the dynamics change if the price ultimately falls below a support level. The prior support level, which previously acted as a floor for the price, can now serve as a ceiling, with traders now considering it as a potential resistance level.

If the price manages to break above a resistance level, that level may change roles and become a new support level. Traders who missed the initial buying chance at the breakout may now perceive the former resistance level as an appealing entry point, resulting in increased buying activity and providing support for the price.

 

Combining Support and Resistance with Candlestick Patterns


The combination of support and resistance levels with candlestick patterns offers traders a more comprehensive view of market dynamics and enhances the accuracy of trading decisions. Here's how this powerful potent combination works.
 

Confirmation of Price Reversals


When a bullish candlestick pattern forms near a support level, it reinforces the possibility of an upward price reversal. Similarly, a bearish candlestick pattern forming near a resistance level adds conviction to the likelihood of a downward price reversal. Such confirmations empower traders to enter trades with increased confidence.
 

Spotting Breakouts


Support and resistance levels act as barriers that can restrict price movements. When the price breaks out of these levels by forming a confirmation candlestick pattern based on the breakout’s direction, it signals a robust continuation of the trend. This breakout confirmation enables traders to enter trades in the direction of the breakout with enhanced precision.
 

Confluence of Signals


When a candlestick pattern aligns with a support or resistance level, it creates a confluence of signals. This confluence reinforces the trade setup and provides traders with higher-probability trading opportunities.
 

Optimizing Trading Entries with Support and Resistance


To optimize trading entries, traders should follow the following steps.


 

Identify Key Support and Resistance Regions


Study historical price data to pinpoint significant support and resistance regions on the price chart. These price levels should have a proven track record of impacting price movements.
 

Recognize Candlestick Patterns


Acquaint yourself with the characteristics of bullish and bearish candlestick patterns. Understanding their visual appearance and formation conditions is essential. Then, you should look for a relative candlestick pattern to form close to these decisive price regions. This confirmation strengthens the trade signal.
 

Establish Entry and Exit Points


Determine precise entry and exit points based on the confluence of signals from candlestick patterns and support/resistance levels. Utilize stop-loss (SL)and take-profit(TP) orders to manage risk effectively.

Regarding a long position, the SL should be set below the support level, as it have the potential to halt downward price moves. Conversely, in case of selling short, the SL order can be determined above the resistance region, where the prevailing supply might possibly reject price surges.

 

Practice and Review


Put your strategy to the test on demo accounts, such as ITB's Demo service , or with small-sized positions to gain experience. Regularly review your trades to identify areas for improvement and refine your approach.

Tips for Effective Implementation


As mentioned earlier, traders should first identify the key support and resistance levels. Here are some tips to maximize the effectiveness of support and resistance levels and identify the important ones.
 
  • Always remember to use multiple timeframe analyses to confirm the validity of support and resistance levels.
 
  • A critical support and resistance level can be identified based on the number of times they have been tested. The more they are tested, the more effective they are.
 
  • Use support and resistance levels alongside other technical indicators and oscillators to gain additional confirmation signals on their strength.
 
  • Regularly review and adjust support and resistance levels as market conditions change.
 

Trading Strategies involving Support and Resistance Levels and Candlestick Patterns


By combining the crucial support and resistance levels with the major candlestick patterns, traders can develop several trading strategies, including trend-following, breakout trading, reversal trading, etc. These strategies aim to capitalize on price movements that align with the identified support and resistance levels and candlestick patterns.
 

Case Studies


Let's imagine a trading scenario involving a currency pair in the Forex market. We will use the Morning Star candlestick pattern in conjunction with support and resistance levels to identify a potential trading opportunity.


 

Step 1: Identifying Support and Resistance Levels


Firstly, we need to analyze the currency pair’s historical price chart to identify key support and resistance levels. Assuming we find a critical support level, where the currency pair has historically bounced back multiple times.
 

Step 2: Spotting the Morning Star Pattern


Next, after monitoring the price action over several trading sessions, we observe a specific candlestick pattern forming. It consists of three consecutive candles and is known as the Morning Star pattern.
 
  • The first candle is a bearish candle, indicating a downtrend.
 
  • The second candle is a small-bodied candle with shadows on both sides, also known as a Doji or Pinbar, representing indecision in the market.
 
  • The third candle is a long bullish candle that closed above the middle point of the first candle, suggesting a potential reversal and a shift toward an uptrend.
 

Step 3: Confirmation with Support and Resistance


Seeing the Morning Star pattern forming near the support level, we have a confluence of signals. This increases the validity of the potential reversal. The pattern's appearance suggests that the selling pressure has weakened, and buyers may be stepping in, which aligns with the support level acting as a price floor.


 

Step 4: Executing the Trade


With the Morning Star pattern forming at the support level, we decide to execute a long (buy) trade. Here's our plan:
 
  • Entry Point: We place a buy order slightly above the high of the third bullish candle in the Morning Star pattern.
 
  • Stop-Loss: To manage risk, we set a stop-loss order just below the low of the second candle in the Morning Star pattern, or the support region.
 
  • Take-Profit: We set our take-profit order just below the resistance levels ahead in the price’s path upward. This allows us to capture potential gains if the currency pair reaches the resistance level and encounters selling pressure.
 

Step 5: Monitoring the Trade


Once the trade is executed, we should closely monitor the price action and update our analysis based on the price behavior. If the price starts moving in our favor and reaches the predetermined resistance level, we might decide to take profits or adjust our take-profit level based on further analysis.

On the other hand, if the price moves against our position’s direction, we enter the loss territory. By monitoring the price action and implementing further analysis, we might decide to re-adjust our SL order, based on market condition.

 

The Bottom Line


Support and resistance levels, when used alongside candlestick patterns and technical indicators, offer traders a comprehensive understanding of market dynamics. Remember that successful trading requires thorough analysis, risk management, and the ability to adapt to changing market conditions.

Always trade with discipline and use appropriate risk management strategies to protect your capital. Also, it is highly recommended to sign up on ITB Demo account to effectively practice support and resistance level.

When these patterns and indicators are applied at the same time with the major support and resistance levels, they create a great toolkit, assisting traders in properly identifying market trends and predicting upcoming price movements and potential reversals.

This lesson deals with the significance of support and resistance levels and how they can be implemented in conjunction with well-known bullish and bearish candlestick patterns to enrich trading strategies and determine optimized trading entries. Keep reading!
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When the price breaks through a resistance level, it could potentially become...

In a bull market, a ____ level is an area the price has difficulty breaking through to the upside.

Which of the following scenarios represents a strong support level?