SUPPORT AND RESISTANCE BASICS FOR THE PRICE ACTION TRADER

Like most people, when I first began learning the price action trading method, I was pretty focused on "signals" - or identifying certain candlestick patterns or combos that could lead to predictable results.  This is an important skill, don't get me wrong; it is this ability that leads a trader to identify possible "opportunities".  However, I found that sometimes my trades went well, and sometimes they did not (all based on essentially the same types of signals).  So, what is it that made some trades fare better than others?  The invisible levels of support and resistance in the charts were affecting my trades in unforeseen ways, and once I truly began to understand support and resistance - my trading success rate skyrocketed.  

A previous post, "Stop-losses, Entries and Exits" touches on the topic of making sure that you're using support and resistance levels (from here on referred to as "s/r levels") when deciding when to get in, where to put your stop loss, and how much room your trade has to run before it's likely to stall (in other words, where you should get out, or at least anticipate having to cope with waiting or even accepting price retracement before it begins to move in the desired direction again).  In case you don't really understand s/r levels that well, I am going to go into this topic in detail here.  

There are really two aspects of understanding how to use s/r levels effectively. The first part is that you have to correctly place these levels on your charts, or they are useless or even harmful to your trading decisions.  The second aspect of it is understanding how these 'correctly identified levels' should impact your choices of whether or not to get in a trade (even if the signal is good), where to place stop loss and exits, etc.  Basically, by placing the s/r lines on your chart, you should be able to somewhat predict the path that price will likely take (remember, we can never be 100% sure - so don't bet the farm).  

Let's look at a pair, it doesn't matter which one - but we'll use USDCHF for this example (a popular pair), and I will describe why I decide to place the s/r lines where I do:

Okay, so I start off with a monthly view.  What I am looking for are the turning points, and/or highest highs or lowest lows of the price action.  I am not going to mark every minor level, but only the ones that are easily identifiable at this point.  Also, I am more concerned with where price "closed" than where it went temporarily (indicated by the wicks of the candles).  Notice how these levels are somewhat evenly spaced apart, you will see this occur naturally again and again with all pairs.  These major levels are the most important.

Now, let's zoom in a little:

Alright, now this is the weekly view of the same pair (all the way to the right of the chart, where price is currently sitting at right now).    Notice how we only see two of the blue lines from the monthly chart where I initially marked s/r levels (so our chart is not overly cluttered).  I drew this red line in just to point out that there is some obvious support going on here - though I am not going to mark it with a blue line because it isn't one of my major s/r levels (I am just making a mental note to myself). Right now, price is butted up against this overhead resistance (top blue line), and if previous history is any indicator, it will probably not break through.  It has been ranging a bit between this support marked in red and the overhead resistance.   It will most likely reverse and continue in the downtrend that it is already in, so I will be looking for a bearish rejection signal (see my previous post on signals) and I would be looking for price to continue down at least until the level of the red line, and if it breaks past that - I would expect it to drop down to the next support level.  That's how price action works, trends tend to continue in the direction they are going in (until they don't! but you're still safest to trade with the trend).  And price tends to flow from one s/r level to the next.  It is when they approach these levels that you need to be careful with entering trades, because they can stop suddenly, stall and consolidate for quite a while, or reverse entirely. These levels are like a predictable area where you can expect some kind of interference with the price movement.

Now, let's zoom in further and look at the daily chart:

This is a close up of a section of the daily chart taken from around July/August 2012.  I am displaying this section to demonstrate a point.  If you are unsure of whether you are doing it right, when placing your s/r lines, you are looking for resistance and/or support (marked with the red lines) and you should see (usually, but not always) strong power candles that push through the levels (such as those circled in red).  If you can identify these two things happening at the levels you have marked, you are probably doing it right.  S/R identification is somewhat of an acquired skill, so with practice you'll easily be able to identify these areas quickly.  Now, let's go back to present day price action on the daily chart:

Here, we can see that price has tested this resistance level three times during this move.  The first two attempts stopped right at our s/r level, and the last one (yesterday and today's candles) broke through with a power candle, and then back down below the level.  We call this a failed break, and some people consider this a rejection signal in itself.  Personally, I am still not convinced enough to put in a short trade.  Now, if I were to see price come up from below to test the resistance level again on the daily or 4-hour chart and drop a nice strong bearish rejection candle, I would consider a short trade.  It would look like this: