Lesson 7: Support and Resistance

This lesson emphasizes the importance of understanding market dynamics, the psychology behind trading, and the value of hands-on experience and community engagement.

Why Support and Resistance?

Support and resistance are foundational concepts in trading. They represent points on a chart where the price tends to find resistance as it rises or support as it falls. These levels are crucial because they often indicate potential trend reversals or continuations.

The Battle of Bulls and Bears

Trading is essentially a battle between two forces: the Bulls (buyers) and the Bears (sellers). Every trade has a buyer and a seller, and the outcome depends on who is more aggressive, who has more resources, and ultimately, who is right. Every day, as a trader, you’re trying to determine which side is stronger and align yourself with that side. When the momentum shifts, you need to be ready to switch sides.

00:30

Support and Resistance: The Basics

Support and resistance levels are where the market tends to change direction. These levels are based on crowd psychology. For instance, if a stock price is moving downwards and reaches a support level, it might bounce back up because traders believe it’s a good buying opportunity. Conversely, if a stock price is moving upwards and hits a resistance level, it might start to fall because traders see it as a selling opportunity.

01:20

Combining Candlestick Patterns with Support and Resistance

Candlestick patterns, which we discussed in previous lessons, can be combined with support and resistance levels for more potent trading insights. For instance, a bullish candlestick pattern at a support level might indicate a strong buying opportunity.

02:40

The Nature of Markets: Price Memory

The markets have a nature, which is that price has a memory. It has a history. For instance, if a stock’s price came down to $10 and then reversed, it’s because someone bought a significant amount of it at that price. They were aggressive enough to push the price away from $10, buying more and more until it reached $20. Then, for some reason, they decided to sell it aggressively back down to $10.

When the stock reaches $10 again, several things happen:

1. Memory of Past Trades: The trader who made money buying it at $10 before remembers that. He thinks, “Last time I bought the stock at $10, it went up.” This is called a self-fulfilling prophecy. He believes it’s going to go up at $10, so he buys it at $10, and it goes up at $10. 04:45
2. New Buyers: There might be new traders who didn’t make money the first time. They see the stock coming down and think it’s a good company. They look at the chart and notice that the last time it was at $10, it bounced. So, they decide to buy it at $10. 05:30

This crowd psychology of piling onto what someone else did in the past is a very human behavior. If everyone thinks it’s going to bounce at $10, it’s likely to bounce at $10.

Market Sentiments and Human Psychology

The market is all about human feelings and perceptions. For instance, Bitcoin is valued at $5,000 because people believe it’s worth $5,000. Similarly, the Canadian dollar has its value because that’s what people perceive its worth to be. If they think it’s too cheap, they’ll buy, and if they think it’s too expensive, they’ll sell.

06:15

Technical Analysis: A Study of Crowd Psychology

Technical analysis is essentially the study of crowd psychology. It’s the visualization of data to paint a picture of what the crowd is doing. Remember the candlestick patterns discussed earlier? They weren’t just random shapes. They represented battles between buyers and sellers. That’s what the market is all about. If you break down the entire market, it’s about one person thinking the company’s stock will go up and another thinking it will go down. The question is, how aggressive are these two groups?

If someone wants to be a great trader, they need to understand that it’s all about crowd psychology. Even the best traders in the world are right only 55% to 60% of the time. However, with the right strategies, one can become incredibly wealthy with that accuracy rate.

07:00

Support and Resistance: The Phenomenon

When a resistance level is broken, it often becomes support. This phenomenon is due to crowd psychology. For instance, if a stock’s price has hit a resistance level multiple times and then breaks through, those who previously sold at that level might now see it as a buying opportunity. Conversely, those who bet against the stock might need to buy to cover their positions, further driving up the price. This dynamic is what makes prior resistance areas act as new support zones.

08:10

Trends in Trading

Trends are crucial in trading. The saying goes, “the trend is your friend until the bend at the end.” Understanding trends and how they interact with support and resistance levels can provide traders with valuable insights into potential market movements.

09:20

For example, looking at Apple’s stock chart, it’s evident that the trend is upward. While it might be tempting to try and predict the top or bottom of a trend, it’s often more beneficial to ride the wave of the trend.

If you identify a resistance level in Apple’s stock and notice that the stock spends a few days at this resistance, it indicates a battle between buyers and sellers. If the stock breaks above this resistance, it could trigger short sellers to buy and cover their positions, further driving up the price.

15:10

Real-World Application: Support and Resistance

When analyzing real-world charts, it’s essential to understand that not everything will be as clean-cut as theoretical examples. For instance, looking at the chart of a company like Microsoft, you might notice that the support line isn’t perfectly aligned with the lows of the candlesticks. This is where the art of technical analysis comes into play. While the science provides the foundational knowledge, the art involves interpreting the data and understanding the psychology behind the price movements.

In the Microsoft example, the support line might be drawn at around $135. However, one might notice that a few candlesticks slightly breach this line. This doesn’t necessarily invalidate the support level. Instead, it’s essential to consider the overall sentiment and the broader picture. If the majority of the price action respects the $135 level, it can still be considered a valid support.

10:30

Risk-Reward Ratio in Trading

One of the critical aspects of trading is understanding the risk-reward ratio. For instance, if you identify a potential buying opportunity at a support level, you need to determine how much you’re willing to risk if the trade goes against you. This risk is typically set by placing a stop-loss order below the support level.

On the flip side, you also need to have a target price or an exit strategy to realize your profits. The potential profit, compared to the potential loss, gives you the risk-reward ratio. A favorable risk-reward ratio ensures that even if you’re right only 55% to 60% of the time, you can still be profitable in the long run.

For example, if you risk $2 to potentially make $15, even if you’re right only a fraction of the time, the potential profits far outweigh the losses. This strategy is the essence of successful trading.

11:40

Trading Strategies: Breakouts and Pullbacks

Trading strategies can vary based on an individual’s patience and risk tolerance. One popular strategy is the breakout strategy, which involves buying a stock as it breaks through a resistance level. This strategy provides immediate gratification, as the stock is either going to move in your direction right away, or it won’t. However, this approach can be risky, as sometimes stocks break a resistance level slightly and then reverse.

Another strategy is waiting for a stock to pull back to a support level and then buying as it starts to move upward. This approach requires more patience, as traders have to wait for the stock to reach the desired price level. However, it can be more relaxing and potentially more profitable in the long run.

When analyzing stocks, it’s essential to identify areas of resistance that the stock has broken through. For instance, in the case of Tesla, there was a noticeable resistance between $575 and $600. Once it broke through this resistance, it could be considered a breakout. However, when the stock price comes back to retest this area, it’s known as a pullback. This retesting is based on the principle that prior resistance levels often become new support levels.

A pullback play involves waiting for the stock to retest a previous resistance (now support) and then buying as it starts to move upward again. This strategy is based on the belief that the stock will continue its upward trend. For instance, if you bought Tesla at $658 and set a support level at $575, you’re risking $100 per share. However, if the stock reaches the top of its range at $920, you stand to gain $300 per share. This risk-reward ratio means that even if you’re right only 33% of the time, you’ll break even.

12:50

The Importance of Consistency in Trading

Regardless of the strategy chosen, consistency is key. Traders should develop one way to trade and stick to it, repeating the process over and over. Over time, they can refine their strategy based on their experiences and results. It’s essential to find a method that aligns with one’s personality and risk tolerance.

14:00

The Importance of Trading Simulators

While theoretical knowledge is essential, there’s no substitute for hands-on experience. For those new to trading, using a trading simulator can be invaluable. Platforms like Trade Ideas offer simulation programs that allow users to practice trading without risking real money. This hands-on experience can help traders understand market dynamics, test strategies, and gain confidence before diving into real trading.

16:20

Engaging with the Trading Community

Engaging with the trading community can be beneficial for both beginners and experienced traders. Live streaming sessions, discussions about market trends, and sharing personal trading experiences can provide valuable insights.

17:30

Conclusion

Trading is a combination of art and science. While understanding technical analysis, support and resistance levels, and market trends is crucial, the psychology behind trading plays a significant role. Engaging with the trading community, practicing with simulators, and continuously learning are essential steps towards becoming a successful trader.