Article
Step 2:Finding Key S/R Areas
Three steps to finding price action setups
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[li]Identifying a Trend
[/li][li]Finding Key S/R Areas
[/li][li]Watching for Price Action at these Key Levels.
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What is S/R
Support and resistance are areas where the market is likely to react to a certain price level. This reaction is created by a shift in supply/demand. While we as traders never know with 100% precision where price will react to in the future, there are tools that we can use to help us pinpoint those areas in the market and look to these for high quality price action setups. The principles behind S/R are easy to understand but using S/R tools correctly can take a while to learn and master. The reason looking for S/R is second on my list 3 step list, is because some of these tools only apply to certain market conditions. If you are in a range or a trend, that will determine if you will use EMAs or the Fibonacci retracement tool. Once you know your market structure you can begin looking at these various tools to find key S/R.
Why do S/R tools work?
Before getting into discussing about the various tools at our disposal, I want to quickly discuss why S/R tools work and what is happening at a market level to cause price action to form. First I want to start off with the most obvious fact and that is every trader is there to make money. This desire to buy low and sell high is what makes S/R key areas so powerful. Traders often look to certain tools to tell them that a stock has bottomed out or reached a top, and when enough traders look at the same tools and come to the same conclusion there is often a predicable reaction at these key S/R areas. For example if the 3 year high of the Dollar Yen is 110.00, and price is approaching this level, many traders will begin looking at this area for a potential short. This is traders are always looking for price to get too high, or too low and capitalize on it. Often these high/low price levels that have formed in the past continue to have powerful effects far into the future. This goes back to the name of my thread “Price Action That Matters”. It’s the “That Matters” part that I am talking about here. As long as these levels matter to the majority of traders, they need to matter to us. The only reason EMAs, Fibo retracements, trendlines and other S/R tools work is because they matter to the market. I want to really hit home that these tools on their own have no power, they only become powerful as the market uses them “en masse”.
What is really happening in these key S/R areas?
Price action forms at these key levels because of one simple principle, and that is the principle of supply and demand. These key S/R areas are where the shift in supply and demand happen, causing price action to form and often price reversals. Let’s go back to the Dollar Yen example. As price is accelerating to the 110.00 area, traders will notice that this is a 3 year high, and could be a good area to sell once price reaches it. Since traders want to sell when an asset is overpriced, the Dollar Yens 3 year high could represent an overpriced state. The more traders that sell into that area on that belief, the stronger the reaction will be against further bullish price movement will be. This is also why tools that have overlapping S/R can be so powerful. This assures you that even more of the market will be trading watching those key areas.
How Price Action plays into this
Price action helps us see the market reacting to a given S/R area. Have you ever noticed how sometimes the market strongly rejects a key price level and then just a few months later that same price level gets blown through without the slights reaction from the market? This all goes back to traders making decisions on whether that a certain price represents an extreme or not. Sometimes as price approaches a key S/R area, the market decides that this is a fair price, and will break through the level with little effort. Price often times will keep running until it hits another important S/R area and the market re-evaluates if it is overpriced or fair value. Because we never know what the rest of the market is thinking we have to wait for confirmation. That confirmation comes in the form of price action candlestick and patterns. pin bars, engulfing bars, flags, double tops/bottoms and many other PA signals tell us how the market is reacting to a certain level. There are two types of signals, reversals and continuation. In both cases, price action will tell us what direction the market believes price should be going next. This is also why I am a proponent of candlestick retracement entries. The initial candle has already given us the signal that the market is rejecting a key price level. Often times retail traders make one final attempt to push through the S/R areas. These attempts present themselves as price retracing 50-70% back up a candlestick before exploding in the opposite direction. While this can add extra risk to a trade, if done in the right way can provide tremendously larger RR scenarios, which will more than make up for the small increase in extra losses you might incur from the extra risk.
All S/R tools are the same
Knowing everything we know now, we can see that all S/R tools are essentially the same. While they all identify S/R differently, but the principle behind them is the same. The list of tools I use to find S/R are ones that I believe are most widely used in the market, and because of that are highly accurate in finding key S/R areas. Some of these are easier to learn than others, and easier to trade than others.
Note: All of the various methods I list below to find S/R, I describe as S/R tools.
Specific tools
Horizontal
Pros and Cons: This is the most simple to trade from and one of the most widely used methods to find areas of support and resistance. Trading from horizontal S/R is the easiest because it is very clear to identify when price action forms from these levels. Often price will move up to one of these areas and form PA candles before back in the other direction. In the case of horizontal S/R, we look for our price action candlestick to protrude out past the previous candles and break through the S/R area. While horizontal S/R areas are easy to trade from, they can be one of the most difficult to use effectively. One could find literally hundreds of minor S/R areas on any timeframe chart. As a trade you have to learn how to find those few, very key horizontal areas on your chart.
How to trade: Essentially and candle high or low could for a horizontal S/R, but the market will not react to most of these levels. This is why we choose levels that historically have had either the strongest price rejections or where many candle highs and lows formed. Obvious and large swing points are good candidates for horizontal S/R, also areas where candles seem to “run into a wall” and form many highs or lows can also be good candidates. The more price has previously reacted to these levels, the more engraved the S/R area becomes on the chart.
Diagonal (Trend Line)
Pros and Cons: Trend lines are much like horizontal S/R lines except can be harder to trade from and even more subjective in nature. They are traded from just like horizontal S/R, except good pullbacks may be harder to identify. Since trends move at a consistent up or down angle, you sometimes won’t get as large pullbacks as you would when price pulls all the way back to a horizontal area. With enough practice you can learn to find good quality pullbacks into a trend line.
How to trade: Using trend lines as a tool can also be difficult. In much the same way that someone can go overboard with horizontal lines, the same can be done with trend lines. I treat these the same way as the horizontal S/R tool, which is I look for the most obvious areas where price has made major swing points, and see if they all fall accurately on a trend line. A big rule of drawing trend lines is never draw lines through price. None of your trend lines should show that price has breached or broken through before. When looking for price to reverse in a key S/R area you want price to originally be moving away from the area and then pullback. It’s when price pulls back to these areas that we look for PA to enter the trade.
EMA
Pros and Cons: EMAs can be one of the hardest tools to find trades from but one of the easiest to set up and use. The reason EMAs are difficult to trade from is that the level you are looking to for S/R is dynamic and always moving with the price. Since the price pullbacks are not nearly as deep (EMA is always moving with price), it can be harder to find the right amount of pullback to look for price action. Also these tools are only used in the case of trends or strong price momentum; in any other market structure they provide little or no benefit. Since everyone using the same chart and same EMA settings will see the exact same lines, it makes them much less subjective. The only downside is that people use different settings for their EMAs, so it’s best to pick settings that are most common in the market seems.
How to trade: In a trending or strong momentum market, you can look at pullbacks into EMAs for price action to form, signaling the market is rejecting those price levels. As a trader you can use the 8EMA as your short term S/R and 21EMA as your medium term S/R. There will be a gap between the 8 and 21 day EMAs. This gap represents any EMA setting between 8 and 21, and helps you capture a majority of traders who use numbers between 8 and 21 as common S/R tools. You can watch for price to pull back and pierce the area between your 8 and 21 EMA lines and form price action signals.
Fibonacci
Pros and Cons: The Fibonacci tool is truly a measuring device. It is essential used to measure the retracement between the current and last swing points. These are only used in markets where there is a textbook trend occurring. There are a couple retracement values the market looks to, to try and find those overprice/underprice extremes. Those levels are 50%, 61% and 100%. There are other levels on the Fibo tool, but they are generally are reacted to the less by the market. The Fibo tool is easy to trade from as the levels it creates are horizontal areas. The tool itself is not very subjective and other traders that use them are looking at the same levels.
How to trade: To use the tool, find the last swing high/low in your trend and draw your Fibo from the very top and bottom of those swings. The tool will show you each retracement level. Watch and wait for price to reach one of these key levels and form price action signals. The advantage of using the Fibonacci tool is that you will be trading with the trend.
