Whenever buyers and sellers tussle over a particular price level, price action often gravitates towards “key levels” where market participants have placed their pending orders. As a result of this activity, traders can generate support and resistance levels to improve their understanding of imminent price action.
Support levels are prices where a downtrend is expected to pause due to heightened demand entering the market at lower prices. Demand for the asset improves as prices decline, which forms the apparent support line. On the flip side, resistance levels, or zones, can also arise due to overwhelming selling interest as a pushback to increasing prices.
Once a support or resistance level has been identified, it can serve as a potential entry or exit point. Importantly, as the price action reaches a point of support or resistance, it will likely do one of two things:
1. bounce back away from the support or resistance level, or,
2. break through the price level and continue in its direction — until the price action meets its next hurdle in the form of another support or resistance level.
Knowing that the market is likely to react in one of two ways creates a variety of trading opportunities. Traders can use support/resistance levels as boundaries behind which to place stop-loss and/or take-profit orders in the knowledge that other traders will also be “defending” or “attacking” those levels.
Moreover, if combined with a broader macro view, traders can pick out strong levels of resistance/support and continually refer to them over time. By keeping a record of previously strong levels, traders can find superb trading opportunities in the future.