The idea of support and resistance is one of the most popular in the short/medium term forex trading. It is possible to give a rigorous mathematical definition of the support and resistance based on the theory of oscillating signals and two dimensional curves, however, forex traders usually do not need it. Any professional forex trader will tell you that often the price hits certain levels several times and bounces off, creating an imaginary lower or upper bound.
The lower bound is called the support and the upper bound the resistance. Figure 1 below displays varying position of Amazon.com (AMZN-stock) between April and November 2011 with the resistance level of $39. Clearly, the stock has been close to moving above it several times but yet it reversed.
The price levels that are known as support which behave like a floor are shown in Figure 2. Clearly, detecting of the supports is a good buying opportunity since this is where traders see a good value and start pushing the price back up.
The concept of the support and resistance level can be generalized to the concept of the trend line. Imagine that during some period of time the oscillating price goes or down. The high frequency oscillating are also bounded but this time this boundary is not constant but goes up or down with the price. This dynamic, time depended barrier called the trend line can also serve as the dynamic support or resistance level.
Figure 3 below show the Newmont Mining Corp (NEM) chart with a linear trend line providing a support for the stock for several years. The strong linearity of the support is remarkable.
Conversely, when the price is trending to the downside we search for a series of declining peaks and connect them by a trend line. This is when you may consider the so-called short position that is the sale with the expectation that the asset will fall in value. Many traders theorize that the support and resistance level is stronger the more times that the price has been unable to move beyond it. The detected support and resistance levels are often used to select the entry and exit points.
One of the psychological factors involved in the detecting support and resistance levels is that the barriers are often arise at the round price level such as $50. Many forex beginners would buy and sell when the price is an integer. Many investors or even large investment banks placed their sell buy orders at the round price levels. Therefore, the level of $55 is more likely to create the support or resistance than $58.97.
Moving averages is another technical indicator designed to predict the short-term momentum of the price. The a moving average is a constantly changing curve that smooths out the past data. It also allows the trader to find the support and resistance. Figure 4 shows that the price of the asset finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down.
Finally, knowing the support and resistance can drastically improve the returns of the short-term and medium term trading Regardless of the method of detecting these levels, they are used to predict that the forex currency will change its direction to the opposite.
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