Support and Resistance
Support
and Resistance
At the core of all technical
analysis theory are two very simple concepts: support and resistance. Support
can be defined as a “floor” through which the currency pair has trouble falling
below. There is no scientific formula for calculating support; it is something
that is typically “eyeballed” by traders, and hence involves somewhat of a
subjective element.
Resistance, on the other
hand, is simply the opposite: it is the upper boundary through which a currency
pair has trouble breaking. Similar to support, resistance levels are somewhat
subjective. Generally, if the market reaches a certain number of times and
cannot sustain a break above that level; it can be identified as resistance.
The reason why price has trouble breaking
these levels is the presence of actual orders around these levels. A support
level is simply a price area where Ask orders tend to be, and so it takes more
than normal Biding pressure to break that level. Similarly, a resistance level is
a price area where Bid orders tend to be, and so it takes more than normal
Asking pressure to break that level.
Support and Resistance in a Range- Trading Markets
One
simple way to use support and resistance in trading is to simply trade the
range: in other words, traders can simply Ask at support level, and Bid at
resistance level. A key advantage of this is that the FX market is range-bound
a majority of the time, making it an attractive strategy for many market
conditions.
The two disadvantages of range – trading:
Trading
in a range generally does not result in substantial gains on a per-trade basis.
When the
market breaks out of the range, generally it will make big moves. As a result,
traders trading with range strategies can suffer big losses when the market
breaks out of the range.
Support
and Resistance in Momentum Markets
Another
way to use support and resistance is to trade outside of the range; in other
words, to anticipate a breakout. This involves placing orders to Ask above resistance
and to Bid below support. The rationale is that the market will gain momentum
once it breaks out of the range, and thus by placing orders just below or above
of support or resistance, traders may be able to profit if the market continues
to move out of the range and they are on the right side of the market. Momentum
trading is a bit counter-intuitive, as it involves Asking at a higher price and
Biding at a lower price.
Oscillators
Oscillators are a class of
mechanical trading tools that offer indications of when a currency pair is
overbought or oversold. A popular oscillator is the Relative Strength Index.
Relative Strength Index
The relative strength index (RSI) is a momentum indicator
that measures a currency pair’s strength relative to its won recent past
performance. As the indicator is front-weighted (more importance is given to
the most recent data), it typically provides a better velocity reading than
other oscillators. RSI is less affected by sharp movements, and filters out a
lot of “noise” in the Forex market. Many traders also use this indicator as a
substitute for volume confirmation, since the over-the-counter structure of the
FX market does not allow for real-time volume reporting.
RSI’s levels are between 0 and 100. Most
traders use 30 as an oversold condition and 70 and as overbought condition,
although some traders may use 20 and 80. When choosing the settings for RSI,
traders should typically use the default time period of 14, since that is what
the market as whole tends to look at.
In general RSI is used in five different ways:
Top and Bottoms – Overbought and Oversold
conditions are usually signaled at 30 and 70.
Divergences
– When a pair makes new highs (lows) but RSI does not, this usually indicates
that a reversal in price is coming.
Support
and Resistance – RSI may show levels of support and resistance, sometimes more
clearly than the price chart itself.
Chart
Formations – Patterns such as double tops and head and shoulder may be more
visible on RSI rather than on the price charts.
Failure
Swings – When RSI breaks out (surpasses previous high or low), this may
indicate that a breakout in price is coming.
RSI was useful in detecting this USD/JPY
short after a crossover of the 70 “overbought” level materialized on the daily.
Following the clear Bid signals, the pair moved down 450 pips over the next 30
days.