The Traps of Support and Resistance

Online Trading Academy Article of the Week

by Sam Evans, Online Trading Academy

Coming up with the title and topic of this week’s article was a simple task for me this time around, as it was directly inspired by a question that I received from a regular reader of these articles. As you know I do like to respond to my readers e-mails as often as I can and when a great topic is brought up during those communications, I always like to address it directly to a wider audience, as I’m sure that the question is not exclusive to just one person alone.

Earlier this week I was e-mailed and asked why I very rarely talk about the terms “support and resistance.” The writer asked me how I could ignore such huge analysis techniques in my articles because support and resistance are so well known across-the-board and in multiple formats of technical analysis education. This gave me the perfect opportunity to address this and answer the question directly.

The beauty of the Online Trading Academy patented core strategy is in its simplicity and ease of execution. With the strategy itself coming directly from the behavioral patterns of the largest institutions and banks who dominate today’s markets, our instructors and students alike, tend to focus on their trading opportunities from the perspective of what the most successful professional traders are using to carry out their own analysis techniques. While there are multiple streams of strategies and theories about how and why prices move in the manner they do, this doesn’t always mean that they are necessarily the correct ones. I will never be surprised by how many people assume that successful trading in the currency markets and also the other asset classes is a highly complex practice. After all, we are making it our business to predict the future I guess and so that dynamic alone tends to raise questions of how challenging trading can be.

Firstly, I would like to shut up all illusions before we go any further: nobody knows what is going happen next in any market. In fact one of the most important lessons that I ever learned early in my career was to approach the market every day with the assumption that I really didn’t know what was going to come next. This helped to alleviate any biases or subjective analysis leaving me unemotional and objective in the process of trading. With this taken into account, it should be obvious to us then, that the only thing that really matters is price and why it moves in the manner in which it does. Prices change and markets go up and down purely as a result of the ongoing changes in supply and demand at any given time. If prices rally higher, this is because there were more willing buyers than sellers, or put simply, because demand was greater than supply. When we see prices fall we know that supply was now greater than demand due to the undeniable fact that there were more willing sellers than buyers at the point of the directional price change.

With these basic and fundamental lessons taken into account, let’s now address the question of the role of support and resistance and how effective it can be when used as an analysis technique in our trading. Pick up any textbook or look at any website about conventional technical analysis and you will no doubt find A number of simple rules around support and resistance. They are as follows:

1. Buy at or near Support
2. Sell at or near Resistance
3. Old Support becomes new Resistance
4. Old Resistance becomes new Support

Trust me, I have scoured a wealth of trading educational content over the years in which I’ve been active in the markets and without a shadow of doubt, the rules above are pretty much universal. Now, I am not saying in any way that using these rules is incorrect or that they don’t work. Personally I have seen many times when these support and resistance rules have proven their effectiveness. However, there must be a solid set of accompanying rules to go with these rules, so as to make them easier to implement and increase their effectiveness. Without a number of filters to accompany these rules, one can become easily confused and fall into the danger of overtrading. Let’s take a look at an example below to show you what I mean:

In this example of the EURGBP, I have drawn in a number of support and resistance lines. Upon referencing the previous rules, you will notice that support can become resistance and that also resistance can become support. With this in mind you’ll see how in the above example there are so many lines because support lines can be doubled up as resistance lines and vice versa, resulting in numerous reference points across our chart. In this example we have seven lines drawn on the chart, which could potentially provide seven individual trading opportunities to us. Buying, applying the aforementioned support and resistance rules from earlier, the question is now which line do we buy or sell at? And so the confusion begins… Now I am speaking completely from my own personal opinion right now but I would find it nearly impossible to decide upon which trading opportunity to take out of the above seven in this example. It becomes pretty much impossible to apply any level of objectivity when faced with so many choices. This is where the problem lies as more trading opportunities can result in lower probability and higher risk. Now we have the simple answer as to why I choose not to use regular support and resistance in my own trading. I would rather apply the dynamics of true institutional supply and demand to my chart and make my trading decisions from there. Let’s now take a look at the chart with the support and resistance lines removed and just a couple of key levels of demand and supply applied instead:

With our levels of supply demand now applied to the chart, the simplicity in opportunity is now so much more clearly defined. Until either of these levels are broken there is little else to do but sit on our hands and wait for a supply or demand level to present itself to us. The reason I choose to wait is because I want to see what the institutions are doing before I take action, rather than simply assuming a previous price level will provide me with a trading opportunity because it was once support or resistance. I can only truly go by what the market is telling me right now because what it was telling me in the past is no longer relative. Once a support or resistance level has been broken it is no longer valid. One of the negatives in some people’s opinions of supply and demand is that there are much fewer opportunities. However I do not believe this is a bad thing as I know from my experience it’s not about the frequency of trades that you take but instead the more important aspect is the quality itself of the trades that you find. Institutions wait for the best prices and show their footprints on the price chart if you know what you’re looking for. This is what we must also do if we hope to be successful in the currency markets as well.

Support and resistance may be common analysis techniques in the vast majority of educational content worldwide but they also are techniques employed by the vast majority of traders on the retail side of the markets as well, traders who more often than not struggle to make profits or breakeven. What this suggests to us is that using the common tools available to everybody else is more likely to get you the same results as everybody else unless you have an edge. In two weeks I will continue this discussion and look further into rules number three and four on our list, highlighting how they can often be widely misunderstood as potential training opportunities and can typically become potential traps for most.

I had written an article two weeks ago entitled, “The Traps of Support and Resistance,” and as promised here is part two. In that piece we discussed the concept of what support and resistance is in relation to technical analysis and charting the currency markets. I managed to cover the four main rules These were as follows:

In what we have covered so far we have discussed four main rules, which are most commonly adopted across the universal community of trading strategies and education:

1. Buy at or near Support
2. Sell at or near Resistance
3. Old Support becomes new Resistance
4. Old Resistance becomes new Support

The focus has been mainly upon the dangers of implementing too many support and resistance lines on a price chart which can often lead to confusion when trying to pinpoint exactly where the best opportunity to buy or sell is on the chart. Taking this into account, the focus was placed upon the Online Trading Academy patented core strategy that recognizes objective levels of institutional demand and supply in any market and allows us to buy low or sell high using low risk and high potential reward setups. Hopefully by now you have a pretty good understanding of what a quality demand or supply looks like from what I explained in the previous content.

The primary focus so far has been on rues 1 and 2, above.

It is now time to move on to the third and fourth rules.

The concept itself is a simple one, in that technical analysis studies suggest that when areas of resistance are traded through, there follows a dynamic shift in sentiment that in turn offers us a new trading opportunity. This concept is especially applicable when trading markets that are consistently making new higher highs and new higher lows, or in the case of a downtrend, new lower lows and new lower highs. In fact it has been traditionally accepted that treating old support as new resistance or old resistance as new support, is fundamentally one of the most effective ways to engage a trend. Let’s take a look at an example below to demonstrate this principle:

In the above chart of USDJPY we can observe the continuous upwards trend and notice how the majority of the time it has been making higher highs and higher lows. Using the concept of previous resistance becoming new support, a strategy which could be considered would involve waiting for a major resistance area to be broken and then extending that line forward making the assumption that it will be tested at a later stage as a new level of support. You’ll notice that while the concept and strategy itself makes sense, the price never makes it back to test the old resistance level as support, thus leaving us missing out on the continuation of the trend. In fact if we study the above price action carefully, we notice that there have been practically no instances where any previous resistance has ever become new support. Obviously this does not mean that this event never occurs but it does also highlight that there are many times when the price will go without us, no matter how rule-based and disciplined we are. So let’s move on later in time with the same currency pair and see if there are any further opportunities where resistance has been broken and so offered us an opportunity to buy a new support. Take a look at the below example and you can see an opportunity forming:

The above chart shows us a double retest of resistance at and around the price of 115.00. Therefore taking into account that now the resistance area has been broken with a large momentum candle, we would then consider using this same line as a support area to buy if the market pulls back to it. The same price that the original resistance area was at would become the new entry price in the assumption that it must now become support. Let’s see how this would’ve worked out as a trade:

As we can see after prices did break through the resistance level, they did indeed fall back to the same area yet failed to respect the price as new support. At this stage we should ask ourselves the question of could things have been done any better? It’s incredibly difficult to place an adequate stop loss order below a single support or above a single resistance line, because the stop loss price itself is not really based on anything. There is nothing more frustrating then when you do get stopped out on a trade, only to see it then work and go in the direction you originally predicted that it would go in. This is actually what happened in the example we’re speaking about, as you’ll see from the chart example below:

According to Online Trading Academy’s educational curriculum, the situation above would be described as a trap. Do you notice how prices fell right back through the resistance level and never once regarded it as support? However, the market did go on to rally significantly from the 115.00 price area after triggering an objective level of demand, which I’ve marked out on the chart. This price action suggests to me that the institutions were relying on people using the old resistance area as a potential entry for support and so trapped most retail traders into thinking this is a good opportunity to buy, when really they themselves had their orders to buy much lower. It could even be assumed that when those people who bought at the higher price were forced to sell as their protective stop loss orders were triggered, they were in fact selling to the institutional buyers at the level of demand a little lower. This is why we think of this as a trap.

Over the years I’ve always taken a healthy interest in educating myself to the highest levels and understanding any subject I’m interested in, in the most thorough way. I also learned the hard way that education in a subject is just the first step and that we need to practically apply it so as to gain all-important experience for ourselves. One of the best ways to get that extra education and experience is to mimic those individuals who have the most success in their field, in this case financial institutions being those individuals. This is why our core strategy models the most successful investors, funds and banks and takes their outlook on the market and applies it for ourselves. Always be aware of the potential traps and pitfalls in anything you do. Knowing the environment is one thing but knowing your opponent is an altogether different dynamic in itself.