Support and Resistance Trading Strategy

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Video Transcription:

Hey, traders. Welcome to video 13 in the Advanced Forex Strategies Course. This is Cory Mitchell. In this video, we are looking at Trusting Support and Resistance. Probably one of the most misunderstood concepts in trading is support and resistance. And also, when it’s commonly taught, there’s no real way that you use it to make money. In this video, we’re going to show you how to do that, brought to you by Investoo.com.

So, trend trading, as always, is where the money is. By highlighting support and resistance areas, we can spot high probability entries for uptrends and downtrends, respectively. As always, our risk will be lower than our potential reward. Can be used on all time frames, but we do want to be aware of what is happening on longer-term time frames.

We’re still going to trade in the direction of the trend, so for an uptrend, you want to highlight areas of support. For downtrends we want to highlight areas of resistance, because these are going to be our entry areas, which is not what’s commonly taught.

Simply, resistance is where a price stopped rising and fell. So, the price is moving up, it stopped going up and it fell. That’s called a resistance area. Support is where the price stopped falling and rallied, so it was going down, stopped falling, and we see a pop in price, and that low is what we call support. So, that’s kind of the textbook definition of support and resistance, which is pretty much useless.

Strong support and resistance are where price aggressively turned and changed at least a short-term direction. These are levels that we care about. Not meandering support and resistance that didn’t really do anything. So, just because the price happened to stop falling and bounce a little bit doesn’t necessarily mean that’s an important level. We want to look for strong levels that at least change the short-term direction.

You’ll notice there are a few similarities to the pocket strategy when we start getting into this, but we’re going to discuss some more misconceptions about support and resistance, and also this strategy is a little bit more broad-based. You can use it to help you with all the other strategies that we’ve covered, to help filter some out, and this one is also going to be a bit more general, so you can apply it in more circumstances.

So, new support and resistance levels, the textbook examples are created all the time, so our job is to figure out which ones are likely strong, so we can trade off of them, and which ones are weak, so we can ignore them or even exploit them. Also, we don’t want to be holding a position expecting strong levels to break. So, in this way, we can use this type of analysis to filter out signals from other strategies.

For example, if we’ve highlighted a strong resistance level, we don’t want to be buying as we approach that resistance level, because we’re actually expecting it to hold, and since resistance causes the price to drop, we do not want to be holding a long position. So, we’ll look at that in the examples.

So, I’m going to show lots of examples in this. We’re just going to go through some charts, and I’m going to do a little commentary, and hopefully that’ll help establish some of these contexts and concepts, and get rid of some of the former, maybe not-so-productive teachings that you’ve gotten from textbooks, which don’t really seem to work.

So, we’re still trading with the trend. We use areas; this is the first point we want to understand. We use areas, not single support or resistance level, which is commonly taught.

So, just because the Euro, USD, or some other pare stopped at $138.52 and bounced off that point, doesn’t mean that’s a strong resistance level, or that it’s even a relevant level. The whole area around it is what caused the price to bounce, not simply that exact tic. All that shows is that was the last transaction that went through. It’s pretty random. It could have been a couple pips difference. It doesn’t matter. It’s the whole area that we want to focus on.

When the trend is down, we expect support levels to be broken. This is also a pretty different concept. Most books say, “We expect things to bounce again.” Not true. When the trend is down, we expect support levels to broken. When the trend is up, we expect resistance levels to be broken. So, remember, the resistance level is a former high when the trend is up. The simple definition of a trend is higher highs, higher lows. So, we’re expecting those resistance levels to be broken.

This is why we continue to trade in the direction of the trend. And why, when we’re trading in that direction. So, for an uptrend, we’re not too concerned about resistance levels, just because we expect them to be broken. In a downtrend we’re not too concerned about support levels, because we expect them to be broken.

So, it’s a pretty common teaching that during a downtrend you go short, or you sell when support breaks, or go long in an uptrend when resistance beaks. So, in a downtrend, when the price makes a new low, you sell. In an uptrend, when the price makes a new high, you buy.

And this approach severely limits profit potential and makes it very, very difficult to find a place for your stop loss. It’s not a good strategy, yet it seems to be very commonly taught, and it’s not ideal.

Instead, we’re going to do the exact opposite. Not the exact opposite, but we’re going to take a different approach. We’re going to look at different levels than those that are commonly taught. So, instead, we’re going to short at resistance in a downtrend and buy at support in an uptrend. Now, remember we’re looking at areas. We don’t need to buy the exact former low, because that’s probably not going to happen in the case of support, or we’re not going to sell the exact former high in the case of resistance. We’re looking at areas.

So, stops are much easier to place when we do this, and we have a lot more room for the price to run in our direction. I’m not going to give a specific target for this, simply because we’re trading with the trend. We can allow it to run if we want. We can apply this to other strategies, and as always, because I love it, 1.6, 2.6, and 3.6 times our risk. That can always be applied. That way you’re getting out continuously throughout a profitable move, locking in some profit along the way.

So, remember, as we’re going through this, during a downtrend, we expect support to be broken, so support is former low points. Most of these are going to be weak, so we do not expect them to hold up. When we take profit, we can take profit near a former low, and then since we’re expecting it to break, we can take another target further down below. And for an uptrend, we can take a target near the former high, and since we’re expecting it to be broken, we can take more profit as the price breaks to that new high.

Okay. So, you may be may be scratching your head and thinking, “That’s nothing like what I’ve learned before,” so let’s go through some charts. So, here we have a one-hour chart of the USD Swiss. Let’s just start here. We have a move that starts here, continues to the downside, so we can see, just based on this, we’re at an overall downtrend. It just made a major lower low, and a lower high here. Then we see this rally here. We’re still making a lower high, and we’ve made a lower low, but this point here changed the direction of the trend. So, this is a potential support area. Let’s just mark it.

But we have to ask ourselves, since the trend is overall down, is this strong or weak? And the answer is, it is likely going to be weak, simply because the overall trend is still down. Even when we get to this point, we can still say, “All right. Once this starts to fall again, we have made a lower high.”

As this is rallying, we have to be able to say, “Is this a strong area?” Is the price likely to rally beyond this point?” And remember, we’re always looking at areas, not that single level. So, the price just fell from here to here. It rallied and has now come back into that area. Is it likely to break that high? The answer is no, because we’ve established that the trend is down. We have a lower low, and we have a lower high. We can assume that and enter in this area, and take a short position, placing a stop, 5 pips above this high. Then our trend is once again confirmed to the downside, and once again, we can use any of the targets we want at 1.6, 2.6, 3.6, we would have gotten all going all the way down.

Or the other approach I mentioned was, during a downtrend, you can take profit near the former low, which would have been this, which is our weak support area. So, we would have taken profits right in here. And then we can take profits lower than that, because we’re expecting that level to break. We have a little bit pop higher here, and then we could have taken profits anywhere down in here. And once again, we can use the other methods and strategies covered to figure out a way to get out. I’m not going to go into where you should exactly get out for that.

Now we have a new down wave, this wave. Now we have another major wave, and we can see it’s a short-term uptrend within a longer-term downtrend. So, I’m just going to draw a trend line on here. The trend line does not matter, as we covered in the trend line video. It can be broken. We’re still looking for areas. So, we have this area before. Now we have this area.

Now at the moment, this is a little bit random. You could zero in on the chart, if I can find it again, to figure out exactly how big these areas should be. But for simplicity, we’re going to keep it at about this size. We’re talking about an area of about 10 pips, and I’d say that’s fairly conservative. This pair is extremely choppy. It doesn’t move a whole lot per day. On a more volatile pare, such as the British pound, JPY, you might want to use a 20-pip range, simply because it’s quite a bit more volatile than this pare. But for this pare, 10 pips works quite well.

So, we had a move that started here. We have this down move, and then we have a short-term uptrend within this. So, this does not indicate that we’re in an overall uptrend. All it does is indicate that we’re in a short- term uptrend within a longer-term downtrend.

So, as the price moves within this uptrend, we can place orders to sell in this old resistance area, by its former high. As you can see, we would have just gotten filled, as we did on that last trade. Stock goes 5 pips above, and we have targets either all the way down, at 1.6, 2.6, 3.6 times the risk, etc. Or we can take near the former lows, which, in this case, could be either here, which is a weak support level. We could have also put them down here, which would have taken a lot longer for them to get hit, and then below the former lows.

In the meantime, if we would have taken 1.6, 2.6, 3.6 we would have likely been out in this area here, and we have yet another trade. So, we have a short-term uptrend within a longer-term downtrend. And once again, using a 10-pip area, that would have just gotten missed if you had adjusted to there. As I’ve said in other videos, we don’t always include extremes. You would have been able to get a fill, but there’s also a good possibility that if you had just used this area here as it was, you would have just missed that entry point, and that’s fine.

So, lower low, lower low again. At this point, we would have used that, and I did actually take this trade, and I lost on it, and that’s fine. We made on two or three of those, depending on whether you got this fill or not, and you’d lose on this one, and that’s fine. We’re betting on the trend continuing and that those areas will hold. Now that this changed the entire trend, so this trend is no longer down, and it started at this point, this point becomes a strong support area.

So, now we no longer have strong resistance, because it’s been broken. That was our last major wave down, and it was broken. We had a short-term uptrend, but it turned into a longer-term uptrend. And it started at this point, which means this is a strong support area. So, now we are looking for support areas, and we do not care about resistance. We are expecting resistance to be broken.

So, as we move up, strong, strong, strong, we pop off this level, so we can see this area’s tested multiple times. We are looking at this area as a potential support. Pops higher. Never comes back to this area, chop, chop, chop, chop, chop. Very strong move here. So, this is a potential area that we want to trade off of. As you can see, the price comes back down. This would be a short-term pull back within a longer-term uptrend. As we can see, we’re still making overall higher highs, higher lows. So, stop would have been 5 pips below, would have been fine, never stopped out, and we’re moving. As you can see, the trend dies out a little bit here. We don’t see quite as strong a movement as we saw here.

But, continuing to move forward, this was the low of that pull back. Support throughout here, so this entire area would become points that we’d want to watch for in the future. Once again, we just miss it, but if you were in a trade, even though we missed this opportunity, and potentially this one back here, when we didn’t quite get filled here, if you had positions, short positions, that helps you determine how strong the trend is. So, the fact that you didn’t get filled here again, and it dropped again. If you’re holding positions, that tells you, “All right, I can hold my short positions.”

So, here again, if you were long, the fact that it doesn’t pull back helps you say, “Okay. I can stay in my long positions. This is still good.”

So, we continue to go through this, and all we’re doing is, since the trend is up, we’re looking for areas of strong support. So, we had a nice strong move here. Reaches above that former high, helping to really confirm that uptrend again. Short-term pullback within. So, this becomes a strong support area. And remember, resistance doesn’t really matter. We’re expecting these to be broken.

So, let’s talk about that one misconception that is taught in a lot of books. It’s to buy on a new high. So, while examples like this are often cited, they’ll say, “Oh, look at how much that went up after it passed that high.” If you look at it typically, if you bought on all of those, this one just went marginally above that. This is a new high, but barely cleared. This is a new high, collapsed after a few bars. This is a new high, and that one went a fair ways. Here’s this high.

Then this one, that creates a new high, but quickly fails. So, it’s not a very high probability strategy. It’s much better to wait for the pullbacks into strong support areas that are in alignment with the trend, in this case an uptrend. Or wait for the price to pull back, and this strong resistance area’s in a downtrend. Because that way, even though you may not get filled all the time, the probability of the trade is much higher.

So, we had this down move, so we would be waiting for a pullback into this area. And if you want to get filled a bit more, you can always adjust your area a little bit, because since we know that support is likely to hold, we don’t expect this wave to come all the way down to this former low. So, we can use something similar to the pocket strategy. The pocket strategy, we wanted to get filled in this area here, just above what we call the pocket of the bars. So, we could adjust this support area to just above that pocket, and we’d able to get a few more fills.

If we went back to a few of these examples, this one we would be able to get a fill no matter what. And this one here, if we had gone into the pocket a bit more, we would have got that fill. And same with the trade back here. If we went into this pocket, we would have gotten that fill there too, and our stock would still be 5 pips above the former high, or 5 pips below a former low.

So, hopefully that changes some of your perceptions on support and resistance, because how it is commonly taught, I don’t find too helpful. This hopefully gives you a few ideas. You may have to go through this video a few times and try to really see how I’m going through this in the commentary, because it is a bit of a weird concept to understand. It’s so different from what’s commonly taught that it may take a few times to really understand it.

Every trade has a stop and target. We put those out when you place the trade. As I left it a little open end with the targets on this one, make sure you establish how you’re going to set your targets for these. I always use 1.6 to 3.6 or 4.6. If that works for you, make sure that you put those targets out when you place the trade. In that case, you don’t have to worry about anything. Don’t touch anything. Just let the trade materialize.

As always, we’re [inaudible 00:21:14] less than 1% of your account. That way even a string of losses won’t significantly draw down your account. These take practice to spot a trade. It will also help you determine probabilities on other trading strategies. Assume that strong areas will hold. We can put out our orders. Once we’ve isolated a strong area and the trend, we can put out our order. For support, you put your stop 5 pips below the last target, or the last strong support area, the low. And for resistance, you put it 5 pips above the last high.

So, don’t take trades where those strong support areas have to break in order for a profit. So, if there’s a strong resistance area right above you, you’re not looking to buy, even if one of the other strategies tells you do it.

We assume that strong levels are going to hold. We also assume that weak support and resistance areas will break. So, if the trend is down, we expect all those weak support areas to be broken. If the trend is up, we expect weak resistance levels to be broken. Once again, stock goes 5 pips above strong resistance levels or 5 pips below strong support areas.

Optional targets, we already discussed. You can use the one, two, three, four, five, six, whatever you want to use. I do always like this approach, because it allows you to take some profit as the price moves in your favor. Trading involves substantial risk of loss. Only trade with capital you can afford to lose.

Test out strategies before using them. Make sure you’re actually able to implement them, and that they work for you. I think this would be most difficult to understand, simply because it’s very different from conventional teaching, and being able to differentiate between strong and weak is something that takes quite a bit of practice. You’ll have to go through and see, “All right. How did the price react to these levels,” and that’ll help you determine whether a level was strong or weak.

So, until next time, happy trading.

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