Support Resistance and Moving Averages

As a price moves up and down on charts, it encounters “barriers” along the way. If a barrier acts like a floor and keeps the price from dropping any lower, then it is known in trading terminology as support. When it acts more as a ceiling and stands in the way of upward moves, it is called resistance.






What Causes Support & Resistance?


When more people are buying than selling the price moves up. These people (bulls) eventually need to take their profits. Likewise, people that are waiting on the wings (bears) and looking for an opportunity to enter short are more likely to do so the higher the price gets. When the amount of sellers overpowers the buyers a resistance level is formed (as shown in the illustration above when the price reached 1.4862).

Similarly, when a price is moving down, there are more sellers than buyers. The sellers will eventually need to cover their short positions and take profit. Likewise, if there are bulls waiting to buy, then the lower the price goes, the more tempting it becomes for them to enter into new long positions. Eventually, the number of buyers will overpower the sellers, creating a support level.

Since many traders use pending orders set at a specific level, the same level is likely to act as support or resistance multiple times until it finally breaks (as seen in the example above as we approach 1.4848 for the second time, now to test it as support).

There can be many different support and resistance levels at any given time, and the wise trader tries to be aware of as many of them as possible so as not to be caught by a surprise reversal. As the price approaches each of these levels, it will either break it and go on to the next, or it will bounce and reverse itself.

Moving Averages (MAs)


By drawing moving averages you can identify additional levels of likely support or resistance. A moving average is simply a line chart that depicts the average value of a series of periods.



There are several different kinds of moving averages. Most are an average of the closing price, though they are sometimes also calculated on the high or the low of the periods being averaged.

When the value being depicted is a straight average with no modifications, we refer to it as a simple moving average.

The blue line in the chart above represents a 21-period simple moving average (21 SMA). At any given time, its value reflects an average of the closing prices of the previous 21 candles. Since the blue line is an average, it is by its very nature slow to respond to sudden movements in price.

The red line in the chart above is an exponential moving average for the same 21 periods (21 EMA). Here, there is more value placed on the most recent candles. As you can see, it responds a bit faster to both the sudden drop in price, as well as the rally that follows. Both kinds can have advantages and disadvantages, depending on the situation.

As depicted in the above example, moving averages can act as both support and resistance when a price approaches them. But unlike regular support and resistance levels, they do not remain at one stationary level and can also move on your chart.


Common MA Strategies


You can use moving averages in multiple ways. Traders often check to see whether a price is trading above or below its moving average to decide if they are a bull or a bear (especially on a longer time frame).

As a price gets closer to the moving average, traders look closely to see whether it will bounce back away from it or break that barrier, just as with any other support and resistance level. As the price moves further away from its moving average, the trade becomes ever more risky as price is thought to be out at an “extreme” (since the moving average is still an average, logic suggests that eventually it will meet again with the price at the same level).

Some people even use crosses of various different moving averages back and forth over one another to signal entries and exits.

Going Further


Advanced tools that can help us identify other likely support and resistance levels include pivot points and Fibonacci retracements and extensions. The common factor among all support and resistance levels is their likelihood to either break or bounce when the price reaches them, which is why it pays to be aware of them.

Avoiding False Breakouts: the Re-test


When the price breaks below a trend line that has been acting as support, it will typically come back up to test that same level again – but this time as resistance. The best short entries are not taken on the initial break, but rather on the second move downwards, following this “re-test” of the level in question.

A successful re-test is defined as a candle body closing outside that level. In the example below, we can see that price broke below the support, failed the first re-test as resistance, and then continued to successfully pass on the second attempt. This pattern is also known as a "good-bye kiss".



The same scenario can be reversed when the price breaks above a trend line that previously acted as resistance. In this case, we look for that same trend line to be re-tested as support prior to taking a long position.

The Trendline Break System


By using trend lines you can form one of the simplest trading systems. In an uptrend, we connect the bottoms of the candle bodies. If we are long from before, we look to exit the trade as soon as the price breaks to the downside. If at the moment, we are absent from a trade, then we may think about taking a short position at this point.




Similarly, in a downtrend, we connect the tops of the candle bodies. If we are short from before, we look to exit our trade as soon as the price breaks to the upside. If we are not yet in a trade, we may consider taking a long position at this point.

 


Next Article: Trends and Trendlines