Support Resistance 3

O'Keefe, Ryan

Using Key Zones

Wed, 25 Jan 2012 14:05:28 | Support Resistance 3

The challenge many traders face is determining which horizontal support and resistance levels have the highest probability of holding price versus which will fail. Although trend and price action have a lot of influence on selecting the right support or resistance level, there are some shortcuts you can use to quicken the process. Key support and resistance zones can be used to increase the probability price will respect the price level and offer you a good trade. Key zones are created by identifying psychological round numbers, range extremes, strong rejections, and turnabouts. These techniques offer the highest probability of success, in my opinion, and I use them on a regular basis.

Using Round Numbers Using round numbers to identify support and resistance is an excellent strategy because it takes advantage of the psychology behind supply and demand. Traders are people, and people like to think in terms of round numbers, allowing you to exploit this trait in the forex market. Entry and stop orders are routinely clustered around round numbers because it is easier to calculate the profit or loss mentally when you're considering a trade. For example, would you rather calculate profit or loss on a trade placed at $1.20 or $1.19836? The more zeros a price has in it, the stronger a barrier it tends to be.

Round numbers are particularly effective to use near the open of a major trading session. When the market is hovering above or below a round number ahead of the London or New York open, it is likely that the market will test that round number as trading gets under way. The reason this happens is grounded in supply and demand. If market makers are looking to move price lower, they may move the market higher initially to generate selling pressure by triggering stops above a nearby round number. The opposite effect is seen when the market makers are looking to move price higher. Traders often refer to this as stop gunning, and though most market markers would never admit to doing it, you can see it play out on charts time and time again.

Bargain hunters can use this market behavior to their advantage by anticipating when it will happen and placing their orders to take advantage of it. If the market is trading near a round number and you believe it may be gunned at the open, place your orders 10 pips above or below the round number. In my experience, when a round number holds after it is gunned, the market rarely moves more than 30 pips higher than the round number before continuing in the opposite direction. When this technique works, it offers a high-probability entry with extremely low risk.

Figure 3.11 demonstrates this technique in action. During an uptrend the GBP/USD moved into a small consolidation phase. On the morning of

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September 10, 2009, GBP/USD was trading just above the round-number price of $1.6500 before the London open. Shortly after the open, GBP/USD traded down to test the round number and reached a low of $1.6479 before continuing to rally higher.

Using Dally Ranges The daily high and low of each trading day represents a key support and resistance level. These are two areas where supply and demand balanced momentarily and formed support and resistance. It is not uncommon for the market to test a daily high or low during subsequent trading days, which gives support and resistance traders another high-probability, low-risk area to enter the market. Understanding the currency price action is important to using a daily range successfully. Regardless of the long-term trend, if the recent trading days were very bullish, you might want to consider buying near the daily low. If the recent daily price action is bearish, consider selling the daily high. The usefulness of a daily high or low range degrades over time, so I recommend using only the last

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two or three trading days with this technique. Figure 3.12 illustrates the GBP/JPY within the context of an uptrend represented by the long arrow. The daily low from Friday, July 17, offered trend traders an opportunity to join the trend with very little risk.

Using Weekly Ranges The high and low prices of a full trading week offer key support and resistance levels for traders, just as daily ranges do. Weekly ranges have greater longevity than daily ranges do and may be respected by the market for several days, weeks, or even months. Identifying the high or low on a weekly chart is simple but doesn't offer much detail to plan a support or resistance trade. Using a lower timeframe will give you a clearer picture of support and resistance along the weekly range. Figure 3.13 illustrates an example of selling the GBP/JPY at the weekly high. Using a four-hour chart to plan this trade, you can determine whether the weekly high is holding as resistance before you sell the currency pair. The long wicks on each four-hour candle illustrate strong selling pressure in that area as price rallies higher, only to be sold back down again. These candle wicks are strong clues that a resistance or support level will hold

and a trade opportunity exists. Traders who sold near $159.70 were offered a low-risk, high-reward trading opportunity along the weekly high.

Long-Term Support and Resistance Traders using price action to plan support and resistance trades should start with very long-term charts and then move to lower timeframes. The longer the timeframe you are looking at, the more likely it is that the support and resistance level will be respected by price. I developed my working theory on this concept not because there is something magic about longer timeframes; rather, more traders are able to identify long-term support and resistance. This is one scenario where the idea of a self-fulfilling prophecy in the market may actually have some merit. Weekly and monthly charts do not change as frequently as daily or hourly charts. The support and resistance levels on long-term charts may be respected for many years before finally being broken. These levels of support and resistance should be known to any support and resistance trader looking for a bargain. They are traded as any other support and resistance level would be traded using the tactics outlined in the next section.

TRADING PRICE ACTION

Identifying support and resistance is only half the battle; to make money, you have to be able to trade them. There are a couple of tactics I prefer to trade price action along support and resistance levels, and you will learn those tactics in this section. You will see these tactics in action when we discuss actual trading methodologies in Chapters 6 through 9. To trade price action successfully, you need to be clear on one critical concept about support and resistance: It isn't a perfect line in the sand. Occasionally, a price will be struck that causes an instant and obvious market reaction, but support and resistance barriers are normally established in a range between a high and a low price. This range represents the support or resistance zone where buyers and sellers are momentarily in balance. The relative balance between buyers and sellers may last a few minutes or a few years, depending on what timeframe you are trading, but the range should be clear. This range is where traders should look to enter a low-risk, high-probability trade along support and resistance.

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