Keep Calm and Trade On Using Key Reversal Levels

by | May 17, 2020 | Editorial | 0 comments

Right when you think you’ve seen it all – something else comes up and surprises you.

And when setting up for the trading day there’s a handful of indicators that I look at each morning.  

But no matter the indicators or strategy there’s one thing that should be watched closely before placing a trade.

I’m talking about support and resistance levels… 

Allow me to show you how support and resistance levels can be monitored…

So you can take advantage of the next turning point in the next turning point. 

 

Support and Resistance

 

The concepts of trading level support and resistance is possibly one of the most highly discussed concepts in technical analysis. 

Part of analyzing chart patterns, these terms are used by traders to refer to price levels on charts that tend to act as barriers.

These barriers prevent the price of an asset from getting pushed in a certain direction and can act as a ceiling or a floor for future prices.

Support is a price level where a downtrend can be expected to pause due to demand or buying interest at a specific price. As the price of a stock drops, demand for the shares increases, thus forming the support line.  

Similarly, resistance zones are created by increased selling pressure when prices have increased.  When buyers are taking profits combined with sellers trying to sell overvalued assets, the price level that is formed is called resistance.

Key Points

  • Technical analysts use support and resistance levels to identify price areas on a chart where there’s a good chance for a reversal of  the current trend. 
  • Support is when price is expected to stop or reverse direction when in a downtrend.
  • Resistance is when price is expected to stop or reverse direction when in an uptrend. 
  • Support and resistance is a concept in market psychology – as traders remember the past and react to changing conditions to predict future market direction.
  • Support and resistance areas can be identified on charts using trendlines and moving averages, Fibonacci, and round numbers.

The Basics

 

Support and resistance levels quickly let you tell if a market has enough room to continue trending in a current direction or if it’s about to pause and reverse course.

Once an area or “zone” of support or resistance has been identified, those price levels can serve as potential entry or exit points.

This is because as a price reaches a point of support or resistance, it will do one of two things.  

Price could bounce back away from the support or resistance level, or violate the price level and continue in its direction until it hits the next support or resistance level.

For a day trader, the timing of the trades placed is based on the belief that support and resistance zones will not be broken. 

But whether the price is halted by the support or resistance level, or it breaks through, traders can bet on the direction and can quickly determine if they are correct. 

And if the price moves in the wrong direction, the position can be closed at a small loss…. and iIf the price moves in the right direction, the move may be substantial for the trader.

Now let’s take a look at an example of how Support and Resistance levels influence the price action of a stock in the future.

 

Source: Thinkorswim

 

In this image you can quickly notice that price reacts with sudden and quick movements at these levels.

As the markets sold off from the peak overnight, it fell right into a support level made by the prior days pivot.  And the traders supported the price at that level and the stock rebounded higher throughout the rest of the day.    

Now let’s take a look at how Fibonacci can show a similar outcome…

 

Fibonacci Support and Resistance

 

Similarly to typical horizontal support and resistance levels, a trader will use Fibonacci retracements as an alternative to finding these price areas.

For example, the Fibonacci retracement tool is a favorite among many short-term traders because it clearly identifies levels of potential support/resistance.

 

Source: Thinkorswim

 

Similarly to horizontal price and resistance, you can use Fibonacci to identify areas of support based on prior pivot levels.  

 

Round Numbers

 

Another common concept of support and resistance is that an asset’s price may have a difficult time moving beyond an important number, such as $50 or $100 per share.

The importance of those levels have traders identifying them at Round Number support and resistance levels.

Most new traders tend to buy or sell assets when the price is at a whole number because they are more likely to feel that a stock is fairly valued at such levels.

Also, most target prices or stop orders set by either retail investors or large investment banks are placed at round price levels rather than at prices such as $50.06.

And because so many orders are placed at the same level, these round numbers tend to act as strong price barriers.

 

Source: Thinkorswim

 

In the previous section we looked at the Fibonacci level where the stock would find support.  In this case, the Round Numbers of 281 and 282 also played a key role in the reversal of the SPYs as it acted as support for the market prices.

 

Wrapping Up

 

The bottom line is this…

Support and resistance levels are one of the main concepts used by technical analysts.  These techniques  also form the basis of a wide variety of technical analysis tools suited for reversal trading and other day trading strategies.

The basics of support and resistance consist of a support level, which can be thought of as the floor under the current market price, and a resistance level, which can be thought of as the ceiling.

And as prices fall and test the support level, one of two things can occur.  Support will hold and prices will bounce back up, or resistance will hold and prices will sell back off.

But if support levels are violated it is likely that the markets will continue lower to the next support level.  At this point the traders will determine if it will bounce or continue lower to the next support level.

Plus as you start to combine multiple support and resistance levels, you can build a much stronger argument as to exactly why the price will reverse or continue lower at specific levels.

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