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 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.