If you are trading in Forex you will probably hear traders mention support and resistance all the time. Its one of the founding blocks for all trading. But what is it and how do we use it? Lets find out!
Support – Indicates an area that buyers are stepping up in the market to support the price of any Forex instrument. For example, if a Forex pair keeps falling to a certain price and bounces off that figure, it means that there is support at that price.
Resistance – As you probably guessed, resistance is the opposite of support and reveals an area where sellers are entering and dumping supply into the market. This than causes prices to fail from going any higher.
Sounds simple enough; here are a few examples.
In this first chart we’ve got the AUDUSD. As you can see, it had found support just above 1.0700, as Forex traders stepped in to buy on any dip towards the 1.0700 level. When we see a chart showing a clear level of buying around one horizontal line, this is defined as support.
In this chart, we see the EURUSD as it traded in February. Greece was just finalizing their debt rescue plan and the EU financial crisis was easing. As a result, the EURUSD was in the midst of a nearly two month upswing from around 1.2600 all the way to almost 1.3500. However, as the chart shows, the EURUSD failed to trade above 1.3500, and twice headed lower after hitting that level. This revealed that Forex traders were selling the EURUSD at these prices; thus creating resistance at the 1.3500 figure.
Why do Forex traders care?
Forex traders use support and resistance as point of reference for potential buy and sell entries. Therefore, if a trader sees that there is support in the AUDUSD at 1.0700, he'll feel better about buying just above 1.0700, since they know that other traders are buying at that level. Similarily, if one wanted to short the EURUSD after its big move higher, selling below 1.3500 may be a good move since there has been resistance at that level which was stopping previous moves higher.
Basically, buying or selling along with other traders is often a winning strategy for Forex traders as it increases the chances of favorable momentum. (Going with the flow can also self destruct when lots of Forex traders try to exit the same position at the same time, but that’s for another strategy. In any we are building into this basic strategy a small risk threshold to prevent getting run over by the herd.