This is a Forex Guest Post provided by Denis Turanovic http://choose-forex.com/:
Support and resistance are a major part of any type of technical analysis, but forex trading is where it becomes absolutely crucial. It should come as no surprise that newbies are bombarded with these notions. In order to change that, all they need to do is progress to full-fledged forex traders. And they simply cannot do that if they have no understanding of what support and resistance are all about.
Defining Support & Resistance
Over the decades, more observant traders have noticed that prices on financial markets fluctuate all the time, but seem to struggle every now and then. It is as if something is keeping them from crossing a particular threshold, or they can't seem to escape a certain range. Until they do, and when that happens, it is usually a massive surge that can really mess up their plans. Still, what they deduced is that the reason why the price of a particular financial instrument seems to gravitate in a certain range is this support and resistance thing.
As the price climbs to its resistance level, it loses momentum and market is actually trying to stop it from progressing any further. It comes as no surprise that individual traders hesitate to commit more funds into this asset, for fear of losing value. On the other hand, as the price drops to its support level, various forces in the market get involved and try to stabilize it. Usually, investors see this as a potential profit opportunity and jump on the bandwagon as the price reaches their comfort zone.
Also, since forex markets are about currencies, central banks also tend to intervene in order to maintain their fiscal policy. All of this makes fx markets especially dependent on support and resistance, far more than any other type of financial market.
Of course, these do change from time to time, as no player, regardless of their size, can afford to keep up this policy indefinitely and eventually the market prevails. But that is of little concern to regular fx traders. All they need to do is gauge and predict these levels in order to set up a trading strategy of their own. That way, they can buy currency close to the support level where it is cheapest and sell near the resistance level, where the profit is greatest.
In other words, traders can acquire currency just before their support level kicks in and boosts the price in the opposite direction, and they can relieve themselves of this financial burden just before resistance does its thing and the prices begin to fall once again. This all has to do with a bunch of traders working independently but taking similar actions with a cumulative effect. Once the price starts to lift off the support level, they all start throwing money at the asset and effectively drive the price up. After the resistance level has been met, they all start selling and waiting for the cycle to begin again.
This all works as long as traders do not overplay their hand. It should be said that there are no guarantees with this type of speculation. There is absolutely no foolproof strategy to handle the inevitable. Support and resistance levels can be breached and they will be breached one time. Traders who end up on the wrong side of the spectrum could lose a lot of money – or gain it.
For instance, if something happens and the price does not stop at the support level as it was "supposed to", then the massive selloff could mean traders are unable to escape serious financial losses. They have to sell it to somebody, but if no one wants to buy, this could be a serious predicament. Likewise, if the resistance level gets breached in a spectacular manner, traders who are fortunate enough to be in possession of the asset in question will jump for joy as generous offers keep pouring in. The thing is, these offers will cease eventually, so those who quit while they are ahead are the true winners here.
Is it all in our minds?
In a way, yes! Support and resistance are, more often than not, results of an arbitrary stance made either on a global scale, with thousands of traders acting simultaneously. Or a handful of major players who have the means to direct or even dictate trends. Thanks to human psychology, support and resistance levels tend to be directly linked to round numbers, as a form of a psychological rather than an economical barrier. It is basically the same principle that makes supermarkets "drop" their prices a single cent short of a round number, like $39.99 instead of $40.
On a basic level, ordinary people associate the first figure with a $30 limit, even though it is only a single cent away from the next one. On fx and other financial markets, this is why support and resistance levels are usually set close to round numbers – if those are breached, then the next psychological barrier will not set in until they reach the next round number. Traders can either take advantage of this rule or try to exploit it by outmaneuvering everyone else.
Finally, it should be said that neither fx or financial markets in general are suited for everybody. Support and resistance levels are as arbitrary as the next thing. The only reason why they play such an important part in fx markets is because of all these important players like central banks and billionaires who have a lot at stake here and will try anything to see their interests realized.
This is a broad subject, however, and we have barely scratched the surface. Between indicators and all the different types of support and resistance, this topic is far from over.