First, let’s define some simple terms to help us understand supply and demand and how they can affect support and resistance.
Supply: In terms of the stock market, supply refers to the number of available shares, also known as the float. A security that has a small supply can see a rapid increase in price when demand rises. A security that has a larger supply takes much more demand to move. Corporate actions such as buybacks or issuance of new shares affect the supply.
Demand: In terms of the stock market, demand refers to the rate at which investors want to buy or sell a security. A high demand generally sees an increase in the price of the security, while a fall in demand generally sees a price decrease. Economic conditions, such as changes in interest rates, as well as corporate actions, such as earnings reports, can both affect the demand for a security.
Support: We define an area of support on a chart by finding price levels where there was previous heavy buying pressure. These levels can be flat lines at a price level or trend lines with an upward slope. Areas of support often signal points of bullish reversals.
Resistance: We define an area of resistance on a chart by finding price levels where there was previous heavy selling pressure. These levels can be flat lines at a price level or trend lines with a downward slope. Areas of resistance often signal points of bearish reversals.
- Steps for success
- Identify zones and how you wish to trade
- Be patient and wait for retests to enter
- Use volume to confirm price action and trend
- Use previous supports as places to set your stop loss
Trading off of support and resistance is one of the simplest and most profitable strategies traders can utilize. We can find pivot zones or levels of support and resistance, and use these as areas to buy (on support) and sell (on resistance). This allows us to scalp between these levels or hold trades over longer time periods with high levels of conviction and success. In this example, we will be using an hourly chart to identify the trend and a 5-minute chart to execute our trades.
We begin by examining our hourly chart. We select our support or resistance candles by finding areas where price quickly reversed when it entered said zone. Simply draw a box from the hourly candle bodies to the wicks above to create these zones. The example below shows an easy way to quickly identify a zone of resistance. Adding a trendline can also confirm we are in an uptrend. In this scenario, our entry would be on a retest of the trendline or a confirmation of the break of this local resistance. We see continued re-tests of these levels because large institutions can never get their full position filled all at once, every time price re-enters these zones more and more of their order is filled. A break of these zones is indicative of these institutional orders being filled or removed.
As we watch price action and wait for our entry, we see an increase in buy volume and our next hourly candle jumps up through this local resistance, we can now start to look at the 5-minute chart to confirm our perfect entry. Our next step is to watch for a retest of the previous resistance level to act as support, or a new floor to build for the next leg up.
Now that we have identified a continuation of a trend we can move over to our 5min chart. We can quickly use the same strategy of drawing pivot zones using candle bodies and wicks to find local areas of support and resistance. Our perfect entry is on a retest of a breakout, or a confirmation of buy volume off of a support. In this example, we have two zones to buy in. Our first entry is off of our local support, and we can use increased buy volume to confirm this. The second entry is safer, as we wait for a clear continuation and a backtest of the breakout. When entering a trade we want to enter on a RED CANDLE that is testing support. Trust your support zones, by entering on a red candle we can ensure we catch the bottom of the move.
Now that we have established how to enter these trades, we need to figure out how to exit and protect this position. We can move stops up as price action continues to climb, setting them on a break below our current support.
Our decisions on when and how to exit depend on a few criteria: how long do we want to stay in this position and how active we want to be in the management of this position.
With a short time horizon in mind, we can continue to actively scalp between these support and resistance zones, adding on the backtests of support and trimming when we find new resistances. If we plan to hold onto this position we can wait until we have found a resistance that price action struggles to pass through or rejects off of multiple times. Volume is your friend regardless of your timeframe, heavy sustained sell volume coupled with rejection of resistance can confirm price reversals.
As price moves from zone to zone, previously drawn zones become less and less effective. Remember the reasons we can trust these zones because a large buyer or seller is sitting there waiting for their entire order to be filled. Once that buyer or seller has been completely filled, the zone loses power and we must redraw. There is no golden rule for how long a zone can stay reliable, but we can have more success trading the most recently drawn zones. Because these zones become less and less effective, it is IMPERATIVE to keep moving your stop loss up to the next zone of support. By moving our stops up continuously we can ensure a safe exit at a zone close to the top.
Congratulations, you have successfully learned and navigated how to make a trade based on simple support and resistance zones! Now go out there, draw your boxes, follow the trend, and have fun!