In technical analysis, support and resistance represent the critical point where the forces of supply and demand meet. The other key points of TA, such as price patterns, are based on support and resistance points.
A support line refers to that level beyond which a stock (or currency pair) price will find buyers and chances of it (security) will not fall. Therefore, it denotes, the price level at which there is a sufficient amount of demand.
Similarly, a resistance line refers to that level beyond which a stock (or currency pair) price will find sellers and chances of it (security) will not rise. It indicates the price point at which there is sufficient amount of supply available to stop and possibly, for a time, turn upward trend.
Kinds of Trends
In the forex market, trends reflect the average rate of change in price over time. Trends exist in all markets (Equity, FX or commodity) and in all time frames (minutes to multiyears). A trend is one of the most important aspects, which traders need to understand. The traders should analyse which way the market or security (stock, currency pair) is heading and should take position based on that.
Following are the different types of trends in the forex market −
- Sideways trends (range bound)
- Uptrend (higher lows)
- Downtrend (lower highs)
Sideways trends indicates that a currency movement is range-bound between levels of support and resistance. It usually occurs when the market does not have a sense of direction and ends up consolidating most of the time in this range only.
To identify if it is a sideways trend, traders often draw horizontal lines connected by the highs and lows of the price, which then form resistance and support levels. Clearly, market participants are not sure of which way the market will move and there will be LITTLE or NO rate of price change.
An uptrend signifies that the market is heading in the upward direction, creating a bullish market. It indicates the price rallies often with intermediate periods of consolidation or movement (small downward move) against the major (prevailing) trend.
An upward trend continues until there is some breakdown in the charts (going down below some major support areas). If the market trend is upwards, we need to be cautious on taking short position (against the overall market trend) on some minor correction in the market.
Another way to figure an upward trend of market or currency price is shown below −
Above the primary waves move the currency pair (USD/INR) in the direction of the broader trend (upward move), and secondary waves act as corrective phases (minor correction in currency, downward) of the primary waves (upward).
A downward trend in the forex market is characterized by a price decline in the currency pair (USD/INR), with slight upward swing for a period of consolidation against the prevailing trend (downward trend). Unlike upward trend, a downward trend results in a negative rate of price change over time. In a chart, the price movements indicating a downtrend form a sequence of lower peaks and lower lows.
As currency is always traded in pair, the downtrend in forex market is not much affected as other financial markets. In case of downtrend of a currency pair (USD/INR), the fall in price of USD gives way to a rise in price of INR. It means something is always going up even in times of financial or economical downtrend.
Another way to look at the downward trend figure is in the form of primary (major trend) and secondary (minor correction) wave, as shown in the diagram below.
In the above figure, the primary wave (downtrend) moves the currency pair in the direction of the broader trend (downward trend), and secondary waves (uptrend) act as corrective phases of the primary waves (downtrend).
A retracement is a secondary wave (temporary reversal) in the direction of a currency that goes against the primary wave (major trend).
Like all other financial markets, foreign exchange market too does not move straight UP or DOWN, even in the strong trending market (Uptrend or Downtrend market). Traders keenly watch several percentage retracements, in search of price objective.
The amount of prices retreat following a higher-high (or higher-low) can be measured using a technique called “percent retracement”. This measures the percentage that prices “retraced”.
For example, if a stock price moves from the one year low of INR 50 to a recent high of 100 and then retraces back to 75 INR, this backward movement of prices from 100 INR to 75 INR (25 INR) retraced 50% of the previous move from 50 INR to 100 INR (100% upward journey).
Percent retracement is strategic for Technical Analysts as based on this they determine the price levels at which prices will reverse and continue upward afterward. During any strong bull or bear market, prices often retrace from 33% to 66% of the original move. Retracement of more than 66% nearly signifies an end to the bull market.
The basic principle of technical analysis is that we can identify future trends and to some extent the duration of that trend (upward or downward). During a bull market, we see a series of higher (upward or primary wave) highs and correction lows (downward or secondary wave) and in a bear market, lower downswings (primary wave) and correction highs (secondary wave).
Drawing trendlines correctly is the legitimate extension of identifying the support and resistance levels and providing opportunities to open and close positions.
Trendlines are drawn at an angle above or below the price.
The above chart shows the trendline with downward and upward trends for a EUR/USD currency pair. In addition, we can the following in the chart −
- Three swing highs on the downtrend
- Three swing lows on the uptrend.
Therefore, when drawing trendlines in a downtrend, we draw them above the price and when drawing trend lines in an uptrend, we draw them below the price.
During a downtrend, it is the high point and in uptrend, it is the low point that will determine a trend line.
For confirmation, we require at least three swing highs or three swing lows to draw a trend line in either direction (uptrend or downtrend). Higher the number of times the price touches a trend line, the more acceptable it is, as more traders are using it for the support and resistance levels.
Using trend lines to trade
Most traders frequently use two methods to trade using trend lines −
- Entry or exit when the price finds support or resistance at the trend line.
- Entering when the price breaks through the trend line.
Trend line as support or resistance
As support is equal to demand and resistance signifies supply, it is the imbalance between supply and demand, which triggers price movement. If both supply and demand are static, there will be no price movement. Security prices stop falling and reverses when support/demand is below the current price. Similarly, security uptrend will stop its upward journey when resistance/supply is above the current price.
So in up trending market, each new resistance (higher levels) will be set. If the security(equity or currency pair) or market is in uncharted territory, there is no resistance level set (can reach any new high).
Support and Resistance Levels in Uptrend
Similarly in a downtrend, the security (equity or currency pair)/ market is making new lows thereby going below the multi support levels. If the security/market is in downtrend and going down below all-time lows, finding exact support levels is not possible (only way is to go with retracement levels.)