Among the various techniques for trading in the financial market, one of them is Price Action, which is probably the most challenging and profitable technique. This model is based on price dynamics, identifying market behavior and using chart patterns to define entries. Patterns are drawn by looking at the chart without any indicators, this technique is known as “Naked Trading”. One of the most commonly used strategies for trading Price Action is the Support and Resistance model.
The support and resistance, or S&R, identifies areas where price has reacted in the past and there may be high chances of rejection in the future. In other words, they are regions where a given asset has difficulty to overcome, either down with the supports or up with the resistances.
Support is the region where buying demand is higher than selling demand and strong enough to “hold” prices above a certain level. It’s basically a barrier that prevents prices from falling. The strength of a support is measured by the number of tests in the region, the more often prices have reversed on the support, the stronger it is and the greater the probability of rejection.
It’s considered a buying strategy, the definition of the regions is made visually and analytically, it’s observed where there was price rejection and a line is drawn with as many “touches” as possible. In the example below, we can see 4 touches on the support line holding prices above 1,13110.
Contrary to support, resistance is the region where seller’s demand is higher than buyer’s demand and strong enough to “hold” prices below a certain level. Basically it’s a barrier that prevents the rise of prices. Resistance strength is also measured by the number of tests in the region, the more often prices have reversed in resistance, the stronger it will be and the greater the probability of rejection.
It’s considered a selling strategy, the definition of the regions is made visually and analytically, it’s observed where prices were rejected and a line is drawn with as many “touches” as possible. In the example below we can see 3 touches on the line that holds prices below 1.13220.
Psychological levels are round number quotations, numbers like 1.50100, 0.83000, 1.1700, tends to be important levels of support and resistance. They are explained by the ease of observation, for example, if someone is going to predict the value of a stock, he is likely to say 40, 50, 65, not 40.12, 50.58 or 65.45. Following this logic, many investors choose round numbers for buy or sell decisions.
In the example below, supports at 0.83500 and 0.84300, resistance at 0.85000:
When a support or resistance fails its rejection test, a breakout occurs. Usually after a breakout there is a large volume of trading, which can push prices down or up in a strong movement. But why does the volume increase considerably during these events?
One reason is because many trades position their stop just above / below these levels, so in the event of a breakout, the stops are triggered and help push the price in the direction of the current movement. Added to this, traders with breakout strategy, knowing the big movement that is coming, enter the trade generating even more force to the movement.
Another pattern that often occurs after breaking a support / resistance is the S&R reversion, that is, a support after breakout starts to work as resistance and a resistance, after breakout, starts to work as support. This is due to a psychological dynamic of the trades that have lost the “opportunity” to profit.
For example, in the chart below we can see the level of 0.84300 shifting from resistance to support. This is because when the price of the asset began to rise, the late investor sees the upward movement and all the profit he is losing from not entering the trade. This investor is hoping for a fall in prices and a second buy opportunity.
As soon as prices reach this level he enters long, reinforcing the new support (former resistance). The investor who entered the market with the breakout, sees prices rising very strongly and psychologically do not believe why they did not enter a larger position, they just look at the profit they are leaving on the table. He also hopes for a second entry opportunity to boost his profit. This trader, seeing the price reaching the same level where he made the first purchase, increases his exposure generating volume to the upward direction. This increase in volume and change of opinion of the trades generates the reversal.
Having defined the most important levels of support, the main strategy is to buy as close as possible to this level. You can position stop loss just below and take profit near resistance above.
Analogous to support, the strategy for resistance is to open a short trade as close to this level as possible with Stop Loss just above and Take Profit on the support below.
Pullback after breakout
In the same chart above, just after the breakout of support, prices tested resistance for a reversal of movement. Entry at this level could be done as shown below.
Conclusion and Warnings
We can use price dynamics to our advantage, using past-generated patterns for future trade decisions. It’s important to emphasize that the strategies only indicate a probability of the next market movement and do not guarantee profit in all trades. No strategy will work 100% of the time.