Beginner

Understanding Support and Resistance

Lesson 3
5 min read


One of the fundamental aspects of technical analysis in cryptocurrency trading is understanding the concepts of support and resistance. These critical levels are used by traders to make strategic entry and exit points based on where they speculate price will react.

This article will provide an introduction to these concepts and explain how they can be applied in your crypto trading strategy.

What are Support and Resistance?

In the context of technical analysis, support and resistance levels represent key price points on a chart where the forces of supply (selling) and demand (buying) meet.

Support

Support is a price level at which an asset’s price stops falling and bounces back upwards due to increased demand or buying pressure. Traders see the support level as a 'floor' that's propping up the prices, suggesting that the asset is either undervalued or at a bargain at this level.

There are several ways to identify support levels. One of the simplest methods is to look at historical price action. If the price of a cryptocurrency has fallen to a particular level multiple times but each time it has risen again, this level is a strong candidate for a support level.

The rationale behind the creation of a support level is that as the price gets closer to support, the asset becomes more attractive to buyers while sellers become less willing to sell. Once the price hits the support level, it is thought to bounce back up.

Resistance

Resistance represents a price level at which rising prices stop, change direction, and start to fall due to increased supply or selling pressure. Traders view the resistance level as a 'ceiling' keeping prices from heading higher.

Resistance levels are usually identified by looking at the price history. If the price of a cryptocurrency has risen to a particular level multiple times but each time has fallen again, this level is a strong candidate for a resistance level.

The creation of a resistance level works on the principle that as the price gets closer to resistance, the asset becomes less attractive to buyers and more attractive to sellers. Once the price hits the resistance level, it is thought to bounce back down.

The Role of Volume

Volume plays a crucial role in confirming the strength of a support or resistance level. If the price reaches a support or resistance level with high volume, it's more likely to respect that level because it suggests a lot of trading activity and interest at that price point. Conversely, if the volume is low when the price reaches these levels, the likelihood of a breakthrough increases.

Volume Profiles

Volume profile is a charting feature that displays trading activity over a specific time period at specific price levels. The volume profile is then used to identify trading patterns based on volume concentration and price. It's typically displayed on the vertical axis of a chart.

In the context of support and resistance, high volume nodes (HVN), where a high amount of volume has been traded, can act as potential support or resistance areas. This is because these are price levels where a large number of transactions have occurred, reflecting a consensus on value.

Conversely, low volume nodes (LVN) can be areas where price moves quickly through, creating potential breakout or breakdown zones. If the price breaks a support or resistance level on high volume, this can be seen as a strong signal that the break is valid and not a false breakout or breakdown.

Volume Weighted Average Price (VWAP)

VWAP is a trading benchmark used by traders that gives the average price a cryptocurrency has traded at throughout the day, based on both volume and price. It's crucial for investors who aim to buy or sell in large quantities without dramatically affecting the market price.

In the context of support and resistance, VWAP can act as a dynamic level of support and resistance throughout the trading day. Because it's considered a "fair price" benchmark, if the price is below VWAP, it could be considered a good buying opportunity (support). Conversely, if the price is above the VWAP, it could be a good selling or shorting opportunity (resistance).

Other Volume Indicators

Other volume indicators like On-Balance Volume (OBV) and Chaikin Money Flow (CMF) can also provide insights into support and resistance.

On-Balance Volume (OBV) is a momentum indicator that uses volume to predict price changes. OBV adds volume on up days and subtracts volume on down days. If OBV is rising, it signals that buyers are willing to step in and push the price higher. If OBV is falling, it means that sellers are taking control. In this context, a rising OBV could indicate that support levels will hold, while a falling OBV could suggest that resistance levels might hold.

Chaikin Money Flow (CMF) is another volume indicator that reflects the flow of money into and out of an asset over a certain period. If CMF is positive, it suggests the asset is likely to break through resistance, while if CMF is negative, it suggests the asset is likely to break down through support.

Role Reversal: When Support Becomes Resistance and Vice Versa

An important concept in technical analysis is that once a resistance level is broken, it often becomes a new support level, and vice versa. This role reversal occurs because traders and investors remember these price levels and the market sentiment that created them.

Conclusion

Understanding support and resistance levels is a fundamental part of technical analysis and a crucial aspect of an effective trading strategy. These levels can give traders insights into potential reversals or breakthroughs, providing opportunities for buying low and selling high.

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Published on
July 26, 2023