How to Draw Support and resistance?
Support and resistances are so fundamental to technical analysis that every trader uses it either independently or in conjunction with other trading indicators. One must master the process of drawing supports and resistances in order to increase the accuracy and increase the reward to risk ratio. I will share some of my learnings to draw a support and resistance. This is my method and works well for my style of trading. You are free to analyze the process and take them as inputs.
Support and resistances are more of a zone and not exact levels:
As mentioned above, supports and resistances are one of the most used constructions in technical charts. However, there is little consensus on the exact way to draw a support or resistance. Every trader has it own way of drawing support and resistance. That is why the exact levels are difficult to predict.
Let's take an example to understand why exact levels are difficult to draw. Let's assume that there is a single method of drawing support and resistance. Everyone knows about it and the exact levels are drawn by each trader. Now imagine that a resistance was drawn using this method on a chart. The resistance was found at 100. Every trader has marked 100 as a resistance on their charts. Now consider the situation of buyers who have bought the share at 95. If they want to book profit they have to sell it to someone at a price above 95. They will be waiting for price to reach 100 and then they will try to sell it. But since every other trader has drawn resistance at 100, they will not buy at 100 as they know that prices are not going above 100. The holder of the share will not have any buyers to sell it to and thus ends up holding it up. Some of the traders might realize it and try to sell it at 99 as they know that the buyers might not be available at 100. They know that there is some demand at 99 and they will be able to sell the the share to someone. However, if everyone tries this same approach the resistance will shift to 99 instead of 100. The same scenario can be imagined for supports as well.
The above example shows us why the market will not have an exact method of support and resistance drawing. The fact that everyone will catchup to the technique of drawing a good support and resistance will make the process redundant and useless. We should accept the fact that the exact levels to draw support and resistance cannot be found out. Instead, try to find out zones where buyers are interested and zones where sellers are interested. Try to find out where a large number of participants are thinking alike. Try to buy at a level where others are more than ready to buy. Sell where you can sell it to someone. Once you except the idea of support and resistance being a zone, your trading will improve immensely. You will start looking at the bigger picture and the pain of being wrong will disappear.
Look for supports and resistance in higher timeframe.
Higher timeframe analysis provides a better view into the price action. Rather than going into small timeframe and trading the noise, we can look for higher timeframe confirmation and then decide whether the support and resistance identified is consistent with higher timeframe.
Look at the chart above. There are two support zones drawn. The top one was drawn basis the 15 minute timeframe and the bottom one was drawn in 1 hour timeframe. We can see that the 15 minute timeframe support was easily penetrated and 1 hour time frame was respected by the price.
Now look at the same security and see how 1 day timeframe support is being respected by the price even more than 1 hour timeframe. The point remains the same, higher timeframe will give better supports and resistances.
Importance of round level.
Round levels are very important indicator on where the buyers or sellers might be available. Large players like banks, hedge funds etc. do not trade with finer levels. They look at the market with a bird's eye view. They look at approximate levels where they want to make entry. Round levels are where these large players are interested. Let's see one example.
We can see in the above chart how 7300 and 7200 were acting as resistance and support respectively. We can see how the levels are being defended by sellers and buyers. We have to keep in mind that the levels can be breached but we have to ask ourselves- are the prices stable there? Each time the prices crossed the support or resistance they were either volatile or were immediately thrown back. This fact is consistent with our first observation of support and resistance being a zone. So the next time you see price near a round level find out if the level has seen some price action in the past.
Give more importance to recent price action.
Recency of price action holds more importance in drawing support and resistance. It is possible that price has behaved differently around a level in the past but the recent price action has not respected the level. This indicates that the price has changed its behavior now and has shifted the support/ resistance. Let's try to understand the concept with one example.
See the same security and how support and resistance are shifting. The first support on the left was 6860 but when the level was breached the price created a new support at 6800. This level of 6800 was now being respected more than the original support. Similarly, the original resistance of 7040 was breached and new resistance of 7100 was created. The next time price approach 7100 it gets rejected downwards. This observation indicates that the prices give more importance to recent price action. We can also see that the shifted support and resistance are round numbers (7100 and 6800) which is in compliance with our round number principle stated earlier and hence better support and resistance.
Polarity principle
This principle states that often when a support is broken it becomes a resistance and vice versa. This is also called " Role reversal". This principle can help us find future supports and resistances and has direct impact on getting good entries in a trade. Let's try to understand this with one example.
As explained, in the image above we can see how polarity principle is helping us to find out the most appropriate supports and resistances. The beauty of this principle is that we can predict on how important a level can act if approached from other side. We can devise a trading strategy around it. We can see the principle working beautifully in smaller timeframes as well.
I use this principle extensively and to me this is a gold mine. A powerful principle like this working accurately in all timeframes gives an edge over the market if used judiciously.
Conclusion: In this post I have tried to explain some of the principles that I use to draw supports and resistances. I could have been prescriptive about the exact process I use but then you would have difficulty building your own system. I would suggest to go on your own and find out what works for you. I have used the same stock in all my pointers purposefully to show how the underlying concepts can be applied in one chart and in multiple timeframes.
Write to me in case you want to understand more on the concepts and process. Happy learning.
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