Lesson 5 – Trading Support and Resistance
“A man should look for what is, and not for what he thinks should be.”
For example, let’s say there are fundamentalists and technical analysts shopping in a mall. The fundamentalists would first visit each store and study the products before making their purchasing decision.
Technical analysts, on the other hand, will disregard the intrinsic value of the products in the stores, but instead focus on the people that are entering the stores.
From the pattern of activity observed from the people visiting the stores, the technical analysts will then formulate their purchasing decision. This decision making process is actually based on several assumptions.
Assumptions of Technical Analysis
- The Market Discounts Everything
Technical analysts believe that the market price reflects the intrinsic value of a currency based on the laws of demand and supply. Since the market price has already taken in consideration of all the fundamental factors, all that’s required is an in-depth analysis of the price data to predict the future direction of the price movements. In other words, by studying the price data, the technical analyst is indirectly studying the fundamentals.
- Prices Always Move In Trends
The exchange rate of a currency can move upwards, downwards or sideways. Once a trend is established, it will normally carry on for a while. Identifying trends is only a simple matter of plotting the price data on a chart and seeing the prevailing patterns as graphically displayed on the chart.
- Repetition of History
Through the study of human psychology, it has been noted that human nature as a collective tends to behave in more or less the same way in response to similar situations. Hence, observations about the historical movements of prices are enough to give a technical analyst an idea about the future direction of the market.
Technical analysis is a helpful addition to your trading system. Different traders prefer different tools or indicators. While it is enough sometimes to incorporate just one of the below indicators into your trading plan, using more than one can remove false signals – and that’s got to be good.
This lesson will show you how to apply various methods of technical analysis into your trading. It will include Pivot Points, Fibonacci Ratios and methods for finding areas where multiple methods of technical analysis all agree with each other, or confluence of signals, as it is properly called.
So, more importantly, what are they used for? Well, there are two real ways to use them. The first is using them to highlight current market trends. If the market is currently trading above P, the main pivot point, then the market is considered bullish, i.e. is going up. If the market is trading below P, it is considered bearish, i.e. is going down.
The chart shows weekly pivot points plotted on a daily chart.
The second real way of using pivot points links back to support and resistance. On the chart below, wider pivot lines have been drawn across the screen, keeping the same settings as before.
What is interesting here is how price reacts to these key levels. As you can see in the image above, they work like good support and resistance levels. But how can you use them? Below is a simple strategy using pivot points that works on multiple timeframes, but it’s also a good idea to look at 30-minute charts and daily pivot points.
Below are some of the basic steps, but you should also try to build in a risk management system for this, and work out good areas to put stops using some of the techniques described in previous lessons.
This will help you to build up a strategy. You can then start by playing with this on a demo account and then building it up.
The steps are as follows:
Check the daily and weekly charts for overall trend and write this down, this will be the only direction you are allowed to trade in.
Then, on the 30 minute chart, plot your daily pivot points (most platforms come with this as a standard indicator).
Finally, you need to track the ATR (this will be covered in more detail later but for now, just plot it on your chart and mark down the value when you take a trade).
So, what are you looking for?
If the market is in a downtrend on the daily timeframe, then look for price to move up and test the R1 level, fail to break it and move lower. Then initially aim for the main pivot point, P, and if this is broken, then aim for S1 and S2.
If the market is in an uptrend on the daily timeframe, look for price to move down to S1, fail to break and move higher. Then initially aim for the main pivot point, P, and if this broken, aim for R1 and R2.
Here are some examples based on the EURUSD
First of all, work out the trend.
As the daily chart shows, there is quite an obvious downtrend and it’s clear that the fast EMA is lower than the slow EMA as a confirmation.
Therefore in step 1, only take short positions.
Next, going down to the 30-minute chart, use your indicator to plot the pivot points using daily bars.
The chart below shows a random day and the first potential play.
The blue circle shows price hitting the R1 line. You then need to target the pivot point, and price duly hits this before pushing higher.
The chart below shows the next day. Here, price doesn’t quite reach R1, but then breaks lower through the pivot point, straight down to S1 pivot.
On the next day, there is a nice test of R1 and a move to P.
Finally, today the price nearly hits R1, breaks P, hits S1 then breaks this and goes all the way to S2.
Hopefully, you are starting to see how you can build this into a good little strategy.
What you need to do now is work out a good stop placement and risk reward strategy for this. You also need to look at which pairs it works well for and consider the timeframes you want to trade on: which ones does it work better for?