It is important to spot support and resistance levels.
But it is even more important to determine when the market has been rejected from support and resistance levels, or better yet, how to spot false breakouts so we do not get trapped by them. In this article, I will explain the methodology I use to determine:
- When the market has been rejected from an important long-term level
- When the market is trading at an important level
- False Breakouts
First things first, we need to make sure we are using the right methodology to determine important support and resistance levels.
By definition,
Supports are levels or zones where the market has been rejected more than once, preventing it from falling below that zone or level. The more times the market has been rejected from such a zone, the more important the support level becomes.
Resistances are levels or zones where the market has been rejected more than once, preventing the market from trading above that zone or level. The more times the market has been rejected from such a zone, the more important the resistance level becomes.
Once the market breaks an important support level, it becomes an important resistance level and by the same token, once the market breaks an important resistance level, it becomes an important support level. Under these circumstances, the balance of support and demand changes. When the market breaks an important support level and it becomes resistance, what was thought as a “cheap” price (the support level kept the market from falling below this zone) becomes an “expensive” price (and the market is likely to get rejected as it approaches to this level as bears are likely to take the command of the market around that zone).
Why are these support and resistance levels so important? Because at those levels the market is likely to be rejected:
When Long – If a long position is entered near an important support level, the likelihood of our trade increases in our favor (since the market was previously rejected around this zone or level) – bulls outnumber bears.
When Short – If a short position is entered near an important resistance level, the likelihood of our trade increases in our favor (since the market was previously rejected around this zone or level) – bears outnumber bulls.
Okay, we know what is likely to happen when the market approaches to an important long-term support or resistance level, now we need to know when to take proper action.
A key to spotting false breakouts is that important long-term support and resistance levels are not levels, but ranges or zone. You might want to test this. Pull up any daily chart and you will see that important support and resistance levels are okay even if you move them a few pips up or down. The best way to define the range or zone in which each long-term support or resistance is valid, is by looking at the short-term charts.
Let’s take a look at some charts to clarify this concept.
This is the GBP/USD daily chart:
In the GBP/USD daily chart, the market seems to be trading below an important support level (which makes it a resistance level). At the moment of this chart, many traders would be looking for shorting opportunities, as the GBP/USD is trading below the important long-term support level.
This is an excerpt from January 2010 issue of Forex Journal.
