What makes this concept the most critical forex indicator for price reaction?
Once you grasp the fundamental meaning of support/resistance your trading automatically bounces to a new level. Why is this? Because there are levels in the market that have been respected by price in the past and will be in the future, you can bank on it!
To get a handle on the concept consider who the big players in the market are, and how and why they move price.
The big dogs in the banks and the large financial institutions are not like we retail traders. For starters, a large financial trading institution may hire dozens, even hundreds of traders to trade their book:
Since each of these traders potentially trades in a slightly different manner, this supposedly spreads the banks’ risk across a number of different styles, time frames etc.
And of course, the combined grunt of all those traders moves the market far, far more than we retail forex traders are ever likely to do. It really is a case of the whale and the minnow (or should that be Krill?)
The bank traders will conduct their trading with an eye on certain levels. They may personally have a list of such levels, and the research departments attached to their bank will be notifying them on a regular basis of significant levels to watch out for in the market.
You can see this evidence in any bank report.
Here is a sample extract from a bank report to illustrate:
EURUSD – BULLISH
A break above 1.2824 would extend the latest strength to 1.2935. Support lies at 1.2626.
USDJPY – BEARISH
The risk is for the test of the important support area at 77.91-77.66. Resistance is at 79.03.
GBPUSD – BULLISH
The important resistance is at 1.6052 – a break above would be an outright bullish development.
Support lies at 1.5930 ahead of 1.5882.
… and so on through the various currency pairs it goes.
So the forex bank traders are eyeing certain levels. They will also have certain orders to fill for their clients, if that is the particular nature of their trading role with the bank. For example, they may need to fulfill a large purchase or sale of the yen against the greenback for a Japanese automobile manufacturer.
The trader will attempt to get the best prices possible for the manufacturer, and may have to scale into the position depending on price fluctuations over the course of the trading session or day.
This trader then may be very focused on a near-term price level that they are watching, and as price approaches that level will exercise greater care in scaling into positions for the manufacturer. Of course it may also be the case that the level they are looking at represents an excellent opportunity to fulfill all or part of the manufacturer’s order.
In either case, when price approaches the level, the trader may place a very large order, causing price to bounce either up or down depending on whether the order was a buy or sell. This is the organic, fundamental reason for large price bounces at significant price levels: very large traders are watching those levels with a heightened interest.
So how does this look to the trader on a chart? Here is an example:
You shouldn’t need a support and resistance indicator to draw the line
through logical levels of support and resistance on this chart
Here we see price falling at the left of the screen. The blue line signifies a support resistance level, at this stage unconfirmed. When price first breaks through that level to the downside, it briefly retests (the first arrow) and then falls away. Later price bottoms and begins to rise.
When it again reaches the blue line – the resistance level – it fails, not once, not twice but three times before it finally breaks through to the upside. This is the first indication that an old price level has become a support/resistance level.
Price then rises away from the blue line before coming back to retest it. This is extremely common behaviour, and forms the basics of all support resistance levels trading that forex traders look for
Notice how price retests the area surrounding the blue line twice, and twice moves away to the upside. This further confirms the level indicated by the blue line as a significant support resistance level. Traders will note this!
There are many reasons for an arbitrary price level to become an area of support and resistance. Factors such as round numbers, pivots etc can all play a part. Or it may simply be that for one reason or another this price point was an area where a very large volume of trading was conducted in the past. The market henceforth “remembers” this area and price will likely react when it revisits that area.
Why is this?
Suppose you had sold a very large order of the AUDUSD currency pair at 0.9590 cents. You were betting on price not exceeding that level to the upside. But you got it wrong, and price pushed through and went as high as 0.9650.
You are now 60 pips down, if indeed you are still in the trade. You will likely be hurting severely. You will likely be hoping for price to return to your level of entry – 0.9590 – so that you can exit without a loss. And this is the essential, fundamental dynamic of how support/resistance levels work.
Because, let’s suppose price does fall down to your entry-level. You exit the trade. How? By buying the currency pair. If your order for buying is sufficiently large it will cause price to bounce to the upside. You have in effect pushed price away from an old level of resistance that has now – with your help – become support. The support/resistance line has toggled from resistance to support. Simple, isn’t it? Yes it is, and extremely effective.
Support resistance levels constitutes one of the very best forex indicators for price action trading. That is the bottom line for any trader, and you really need to get your head around this beguilingly simple concept in order to progress as a trader in the forex markets.