Welcome to the second part of our exploration into the dynamics of pretty much the most basic, yet fundamental and powerful aspects of Technical trading: Support and Resistance. I love talking about this subject and pretty much without fail, whenever I am teaching a new batch of students in the Online Trading Academy worldwide centers, I always end up spending as much time as possible with them going through as many examples of why any trader using a thorough understanding of this concept is already well on their way to attaining ongoing trading success in the lowest risk manner. In my last article, I detailed the simplicity of price Support and price Resistance levels and also the many advantages of starting with this form of analysis before applying any other form of lagging or overly complicated price indicator. This week, we add a few more layers to the cake with a look into the application of Supply and Demand and significant price points.
I get many questions via email with regard to Supply and Demand and this is understandable considering that in most trading forums and educational content, it is rarely mentioned. Usually, we read or hear about good old-fashioned Support and Resistance instead. One of the most common questions I am asked is simply, “Are Support and Resistance and Supply and Demand the same thing?” Well, in their most basic elements, the answer is “yes,” but when we push a little deeper, it would then be a “no.” Confused yet? Let me explain.
Support is, by definition, an area where prices failed to go lower and rallied due to the basic fact that there were more willing buyers at that price than there were sellers. On the flipside of this, we have Resistance. This is by definition an area where prices reached a ceiling where they could not rise further due to the fact that there were, at this point, a greater number of willing sellers than buyers. These areas of Support and Resistance become valid points where we as traders can expect changes in the direction of price, thus creating trading opportunities to buy and sell. We talked about this in last week’s article. Some traders will buy near Support and sell near Resistance. Others prefer to undertake the “Breakout” technique, which is more of a momentum-based approach and involves buying as prices make new highs, or selling as prices make new lows. What is better? In my experience, I have employed both methods and found that we need to approach either strategy with separate rules and guidelines. Both systems do work, but require discipline and rules to achieve any kind of consistency. We will talk more about this subject in later articles. For now, let’s get back to our topic.
Before we can even look into Supply and Demand levels alone, we should first gain a solid understanding of significant price points. Another widely used analysis technique is to treat both areas of Support and Resistance as possible trade entries and exits. Obviously, markets do not just trade between these levels. They also trend, forming new highs and new lows, during these stages. Many times over, we will notice that levels of Resistance can be broken, only to then be revisited at a later stage, for the market to then respect the very same area as price Support. Take the below example where we have the GBPUSD testing previous Resistance:
Sometime later, after the level has been tested, we see that the currency pair pushed on higher as the upwards trend continued. Interestingly enough, the previous area of Resistance then becomes a new area of Support for the pair, allowing it to resume its rally once more:
Examples of where price evolves from Support into Resistance, and vice-versa from Resistance into Support, can be found time and time again on any chart of any currency pair or tradable asset. Why does this happen? I like to think of these levels as simple signposts, or anchor points, in price. These are basic, yet incredibly powerful tools for the disciplined trader to use in their speculative activities, but like any other means of analysis, it needs to be controlled, and rules for engagement need to be employed at all times, otherwise, we can find ourselves in tricky and often confusing predicaments.
Take, for example, another currency pair, in this case the AUDUSD. I have for the purpose of the below example highlighted all of the areas on the chart which have been either Support or Resistance areas, or even both. We can say that we have essentially highlighted all of the significant price areas on this chart to create a number of trading opportunities:
So, tell me…are you thinking what I am thinking? What level do I take?! This is one of the worst predicaments to find oneself in. The last thing we want is too much choice. I learned very early on in my trading that one of the most important aspects of trading is knowing when and when not to pull the trigger. In an effort to combat this complexity of choice, we can turn to Supply and Demand levels for a much clearer picture.
So, what defines a Supply or Demand level? Is it the same as Support and Resistance? Well, as I have already said, these two concepts are very similar in so many ways, yet also very different. By definition, a level of Supply is shown on a chart when the number of willing sellers overwhelms the number of willing buyers. Prices thus have to fall. Likewise, we denote a Level of Demand when we see a level on a chart where the number or willing buyers is greater than the amount of willing sellers, causing the inevitable rally in prices. The key to a low risk and high potential reward of any Supply or Demand zone is in the strength of the imbalance between the buyers and sellers. The more out-of-balance the willingness to buy or sell at a price point, then the greater the move away from that price point will be.
Look at the same AUDUSD chart below, with now only levels of Supply and Demand highlighted:
When one compares this chart with the previous example, it is almost like looking at a completely different scenario. When faced with the decision to make a trade, it is always easier to focus on information which is easy to read and comprehend. One of the unique aspects of trading Supply and Demand levels is that these levels give traders a clear and objective way to not only find the greatest imbalances in prices (which is the cause of directional change), but they also easily define risk and reward parameters. As a trader, I prefer less trading opportunities with better probabilities, not the other way around.
So, the next question is, what do we look for in an ideal Supply or Demand level and what advantages does this form of analysis offer the disciplined trader? Well, you guessed it, join me in two weeks for the third part of our study. In the meantime, keep it simple and the losses small.
All the best,
Sam Evans firstname.lastname@example.org