Forex Investment and Currency Trading

One of the basic building blocks of FX technical analysis is the concept of support and resistance:

• Support: A price level where buying interest overwhelms selling interest, causing a price decline to stop, bottom out, or pause. Think of support as a floor for prices in a down move.
• Resistance: The opposite of support. Resistance is where selling interest materializes and slows or overpowers buying interest, causing prices to peak, stall, or pause in a price rally. Think of resistance as the ceiling in a price advance.

Support and resistance level are identified based on prior price action, such as highs and lows and very short-term consolidation periods, known as congestion zones (where prices get all stopped up and can’t move one way or the other for a period of time). Support and resistance can also be determined by drawing trend lines. Still another form of support and resistance comes from Fibonacci retracement levels.

One of the key concepts of support and resistance is that after a support or resistance level is broken, it shifts direction. In other words, after a support level is broken in a move to the downside, it becomes resistance in price attempts to rally. After a resistance level is broken to the upside, it will subsequently act as support for further price gains.

Not all support and resistance are created equal

Support and resistance come in all shapes and sizes. Some support or resistance levels are stronger or weaker than others, and technical analysts typically refer to support as either minor or major. But those terms are subjective and difficult to quantify with any precision.

The best way to get a handle on the relative strength of a support or resistance level is to view it in the context of time and price significance.

• The longer the time frame of the price point, the greater its significance. A weekly high/low is more important than a daily high/low, which is more important than an hourly high/low, and so on, down the time scale.
• Trend-line support or resistance strength is also a function of time frame and durability. A trend line based on daily charts tends to be stronger than a trend line based on hourly prices. A trend line that dates back six months has greater significance than one that’s only a week or two old. Also, the more often a trend line is tested (meaning, prices touch the trend line but do not break through it, or break through it only very briefly and by small amounts), the more valid it is.
• The strength of retracement support or resistance level depends on the nature of the support or resistance during the retracement. A retracement refers to a price movement in the opposite direction of a previous price advance or decline. The distance that prices reverse, or retrace, is called a retracement. For example, trend lines that were support in a down move will act as resistance in any retracement higher. The strength of the trend-line support on the way down, such as how many attempts were needed to break below it, will give a good indication of its likely strength as resistance in the retracement.

Support and resistance are made to be broken

We don’t’ want to leave you with the impression that support and resistance levels are immutable forces in the market that are never challenged or broken. Without a doubt, forex markets spend much of the time testing support or resistance levels, looking for the weak side in which to push prices.

Different trading styles focus on different types of support and resistance:

• Tests and breaks of short-term support or resistance levels are the meat and potatoes of intraday trading. Short-term traders focus on the nearest support or resistance levels as guides to the immediate direction of prices.
• Test and breaks of longer-term support and resistance levels are the fuel that fires longer-term trends or defines medium-term ranges. Medium- to longer-term traders focus on more significant support or resistance levels to guide their trading.

One of the keys to assessing the significance of a break of support or resistance levels is the strength of follow-through that occurs after the level is broken. Follow-through is the price action that takes place after technical support or resistance is broken. After resistance is broken, for example, prices should accelerate higher as shorts who sold in front of the resistance buy back their positions and new buyers enter the market, because resistance has been surpassed. The amount of follow-through buying or selling that materializes, or fails to materialize, after the break of a technical support or resistance level is an important indication of the strength of the underlying move.

Waiting for confirmation

Confirmation refers to price movements that verify, or confirm, a technical observation that suggests a particular outcome. For example, certain chart patterns are useful predictors of a potential reversal in price direction. But note that the central observation in this case is that prices are moving in a trend or steady direction. Blindly following a pattern that suggests that a trend is about to end is very risky. After all, he trend is your friend, so why would you take the risk of going against the trend?

If you’re patient and wait for price action to provide you with confirmation that a trend is indeed reversing, essentially confirming that the observed chart pattern is playing out as you expected, you’re reducing the risks of being wrong-sided or premature in your trade. The trade-off is that you may sacrifice a better entry level for a higher degree of certainty in the overall trade setup. Looked at the other way around, you’re reducing the risks of getting into a trade setup too soon and being wrong if the setup doesn’t play out as you expected.

Technical-based observations provide you with a heads-up alert that a price shift may soon take place – for example, prices may be stalling in a move higher and ready to reverse lower. Confirmation comes when prices break an established trend line, prior high or low, or other key technical levels of support or resistance. Be careful about looking for confirmation from multiple technical indicators, because they may be measuring the same thing, just in slightly different format. Price is the key element of confirmation.