The Art of drawing horizontal lines and how to evaluate their strength.
Identifying Support and Resistance Levels.
This case study is to assist me in better choosing where to place horizontal lines and how to evaluate their usefulness. I will select obvious highs and lows from recent price action to draw horizontal lines, for this I will use red lines. I will determine these horizontal lines from past price action but their usefulness is in the future. Well chosen price levels to draw horizontal lines can serve as boundaries to where price may move to and or reverse from, in the future. In between these obvious support and resistance levels will be other valid points to draw horizontal lines, I call these levels structure high or low, and will use blue lines to highlight them.
This case study will only identify horizontal lines and look to see when they come into play again. I will focus on the battle between buyers and sellers before price return to a line, again. Once price returns to an earlier identified level, I must continue to read the battle between buyers and sellers at the lines. This is a significant battle to understand and to know who is winning, as it will give valuable insights towards whether the line will hold or be broken through. If sentiments are correctly read based on price action at these levels it can help prevent taking low probability bad trades in the wrong direction. Reaction at these key significant levels can be excellent guides towards the medium to long-term trend direction and strength.
Clues towards who is winning the battle, at key price levels, identified by horizontal lines, may come from structure levels and or when higher lows (HL) and or lower highs (LH) are set. When higher lows are being made it suggest buyers are greater than sellers and in control of the overall up trend. When lower highs are being made it suggest sellers are greater than buyers, at the key levels, and will move price down.
Using my combination of support / resistance levels with structure highs and lows has help me avoid a lot of bad trades with low probability of success. Understanding it more and combining it with a few other price action tools should help me identify higher probability trade set ups, and then entries with protective stops and realistic limits.
Here is the EURUSD daily chart with key significant highs and lows identified by red horizontal lines and in between structure highs and lows with blue lines. Below the picture is a definition of how I may use these lines.
Red lines are key support and resistance levels. Blue lines are in between structure highs and lows.
- A support horizontal line is drawn at the lowest low for a chosen time period. The support level will hold if buyers like this price more than sellers and enter the market taking long positions. The absence of sellers at this level will move price higher until sellers see a level they like and enter the market. How do I know, from price action, that buyers are greater than sellers?
- Knowing that a level has held is not an immediate result. When price approaches and reach a support level, depending on the time line being used, the first challenge would be to wait for the bar to close, this is where patience and focus is greatly needed. Once the bar closes, I need to look where it closed. If price moved and closes below the support level, then this may suggest the level is broken. This would happen if buyers did not come in and buy at the support level or if they were outnumbered by sellers. More clues are need to assist in correctly evaluating. For example, after closing below support, if price moves back up and puts in a new lower high then moving back down to the support level this may suggest the level is broken and price should move further down.
- If price bounce off the support line and move higher up breaking structure highs and lower-highs then it suggest the level held. Setting higher lows above the support level is another clue support has held. Further, indicator tools should become aligned bullish. If these fail to happen then the support level may become weak and price may break through it when reached again.
- A resistance horizontal line is drawn at the highest high for a chosen time period. As price approaches and reaches the resistance level, it will hold when sellers are selling more than buyers are willing to buy, here. If more people are selling than buying at a resistance level then it should hold and price move down (of course, if this does not happen then buyers are stronger and price moves up, sometimes it is not what happened but what did not happen that can help read price action).
The further down price moves without significant rallies up shows the strength of sellers over buyers. If price cannot break and close above the resistance level and then proceed down breaking structure support levels with rallies only producing lower highs, this all suggest sellers are in control and price is likely to move further down. When this is happening all indicators should read bearish. If at any time this is no longer true then it may suggest sellers are losing control and buyers may be coming into the market in greater numbers. This is why patience, focus, and discipline is needed to win at forex; when all three of these are being used it can help to prevent bad wrong trades with low probability.
In Part 2, I will review and discuss the above as it played out in USDCAD Q1, 2013. I believe this simple tool of drawing horizontal lines and then reading price reaction at them can be used on any trading instrument and on any time frame. Though, dentifying these levels, especially on higher time frame charts (4-hr to weekly) will aid in analyzing the reliability and limits of price action tools and indicators on lower time frames, 1-hour to 15-minute charts.