The key to trading reversals is in identifying past support and resistance levels.
So how do we truly know if support and resistance was broken?
Trading breakouts is an approach when price tends to move within a tight range over an extended period of time. The direction of the breakout, while uncertain can help determine if there are more buyers or sellers. Or in other words, if a support or resistance level is being formed. The chart below shows how after periods of consolidation or price moving in a tight range, there was a breakout to the downside.
During the process, we notice a moment where price tried to break out to the upside but failed. Traders without an understanding of support and resistance would have seen that as a long entry, but soon would have resulted in a losing trade. The trick is to look to the market structure to the left of the chart. We notice here how past attempts to break out to the upside failed. Therefore, any attempts to the upside should be viewed with suspicion.
After a while price managed to breakout to the downside. But this too should be viewed with suspicion. The trick is to trade on the retest of this breakout, which as shown in the chart depicts how the breakout level has formed resistance. From the chart, we also notice how there was an intermediate support level formed, which is where we would be looking to book profits.
Support and resistance also helps with trading reversals. The key to trading reversals is in identifying past support and resistance levels. In the chart below we plotted a support level based on previous price action. What is Price Action tarding? After a brief rally, we see a downtrend being seen on the charts. Incidentally, we see a sharp reversal from the previously identified support level.
Notice how price makes a very sharp pin bar to reverse from this support level? Without the use of support and resistance, traders would have continued on with their shorts without knowing how price would have reversed when revisiting the past support level. Trading pullbacks offers an effective way to take a safe trade entry.
In the following chart, we show how in a downtrend, price made several pullbacks right to previous support levels which turned to resistance. If you look closely you will notice how the pullbacks happen into the regions of past support levels.
In the above example, we see three such instances which would have offered a great way to trade with a low risk, high probability trading strategy by simply determining the trend and the support and resistance levels. Another support and resistance levels is the psychological numbers. These levels however are not support or resistance levels, but in fact can act as either of the two. For example in the case of USDJPY, notice how the psychological level of acted as resistance earlier on, which in turn became support as price managed to break above it?
Support and resistance levels can also be determined with trend lines. In the following charts, we see a down slope trend line. While the trend lines tend to act as support in case of an uptrend and resistance in case of a downtrend , they also depict the price zones as well. Look closely at the charts and you will notice how price bounced off those levels at first contact. Pay attention to the most recent price action.
To the layman, it might seem as a reversal. But for traders familiar with support and resistance, will know why price bounced off from that level, which incidentally was a strong support level. As can be seen from the above examples, support and resistance forms one of the most basic building blocks of trading.
Look at the diagram above. As you can see, this zigzag pattern is making its way up bull market. When the forex market moves up and then pulls back, the highest point reached before it pulled back is now resistance. As the market continues up again, the lowest point reached before it started back is now support. In this way, resistance and support are continually formed as the forex market oscillates over time. The reverse is true for the downtrend. One thing to remember is that support and resistance levels are not exact numbers.
Often times you will see a support or resistance level that appears broken, but soon after find out that the market was just testing it. There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is not always the case.