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Where to draw support and resistance levels on a chart?

Support and resistance levels are widely used in technical analysis to find prices at which the instrument is considered either overbought or oversold resulting in potential change of trend.

Support level
represents a level at which traders stop initiating their short positions, because they believe that price of the instrument has become cheap enough. When the price of instrument is close to the support level, market is considered to be oversold. Traders then expect that other market participants will find this cheap price attractive and begin to buy the instrument resulting in increased demand and rising price.

Resistance level
is on the other hand a level at which traders believe that price of the instrument is too expensive for opening a long position. When the price is close to the resistance level, market is considered to be overbought. It is expected that other market participants will use the overbought condition to either close their current long positions or initiate new short positions resulting in increased supply and declining price.

It is important to look at support and resistance as levels and not a simple horizontal lines on a price chart. In other words, support and resistance levels should not represent a single price, but rather a zone of certain width that is based on used time frame. As already stated, these levels are created based on a believe, that certain instrument is overbought or oversold. Issue is that every market participant has different idea at which exact price instrument begins to be oversold or overbought. This is why we should treat support and resistance levels as zones. Following chart shows price moving between clearly established support and resistance levels their demand of the instrument, which results in the price stopping its rising tendency or even reversing back or under the previous level of resistance. Between traders, this behaviour is called a β€œpullback” and refers to price breaking a significant level of support and resistance and then returning back to the level.

After price breaks an important level, there are generally three scenarios that can happen:

First scenario
is called a breakout and refers to price surpassing support/resistance level and then continuing to move lower/higher. In this case traders believe that price breaking through a level was justified and believe that it will continue to move in the same direction in the future. Breakouts often happen in the direction of a trend leading into support/resistance level. In following example, we can see clearly established resistance level, that resulted in a breakout, sending price higher in the direction of the overall trend.

Second scenario
refers to a situation where previous resistance level becomes new support level, or previous support level becomes new resistance level. This situation happens when price breaks an important level (in this case resistance), but instead of continuing higher it pulls back to the previous resistance, which now acts as a support. Traders who believe, that price should continue higher will welcome this opportunity to buy for a cheaper price and will buy near or at the new support level. This scenario is illustrated in the following chart.

The last scenario
occurs when price breaks resistance level, but does not continue higher and instead returns back below the level, that now again acts as a resistance. For support level the exact opposite happens, price breaks support level, but cannot sustain a continued decline resulting in price returning above the support level. This situation is known as bull/bear trap, or also known as false breakout, which will be the used term throughout this paper. In relation to prevailing trend in the market, false breakouts are divided into with-trend and counter-trend false breakouts. Counter-trend false breakout occurs when price breaks a level in the direction of prevailing trend, but then returns back below/above the level and continues in the opposite direction to the trend. With-trend false breakout would be the opposite and is illustrated in the following chart for better clarification. Large institutional players will expect, that most stop-loss orders will be right below the support level. If the price breaks the support, these orders will be triggered and traders who bought before the breakdown will be forced to sell their positions. Additionally, breakout traders will now change their bias from bullish to bearish and will open short positions, anticipating price to move lower. This offers needed liquidity for large institutional players, who are looking to buy large positions in the market. This increased demand caused by institutional players will drive price higher above the support level, triggering stop-losses of traders who sold on the breakout. This will further fuel the price higher. This situation is also known as stop hunting. Stop hunting is a strategy that attempts to force some market participants out of their positions by driving the price of an asset to a level where many individuals have chosen to set their stop-loss orders. The triggering of many stop losses generally leads to high volatility and can present a unique opportunity for investors who seek to trade in this environment.

Vlastimil Bijota is a co-founder of investro.com, who has been dealing with financial markets and blockchain for more than seven years. He is an investor in several fintech compani...

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