Trading Strategies #1 - Understanding Support and Resistance Levels
I will talk about the concept of Support and Resistance in trading.
Before that, let's understand why these levels are important.
Support Level: This is the price level where an asset tends to stop falling. It's like the floor that supports the price.
Resistance Level: This is the price level where an asset tends to stop rising. Think of it as the ceiling that resists the price from going higher.
Why Are They Important?
These levels help traders make decisions about entry and exit points.
Example of Support:
Suppose Asset X has fallen to £50 multiple times but hasn't gone lower. This £50 level is acting as support.
Example of Resistance:
Asset X has risen to £70 several times but hasn't surpassed it. This £70 level is acting as resistance.
How to Use Them in Trading
Buying at Support:
If the price approaches a known support level, traders might consider buying, expecting the price to rise.
Selling at Resistance:
When the price nears a resistance level, traders might sell or short, anticipating a price drop.
Breakouts:
Sometimes, the price breaks through support or resistance levels.
Breaking Support: If the price falls below support, it might continue falling.
Breaking Resistance: If the price rises above resistance, it might continue rising.
Example Trade:
You notice Asset X has support at £50 and resistance at £70.
Strategy: Buy at £52, anticipating the price will rise to £70.
Set Stop-Loss: Place a stop-loss at £49 to limit potential losses.
Take-Profit: Set a take-profit at £68.
Calculations:
Potential Loss: £52 - £49 = £3 per share.Potential Gain: £68 - £52 = £16 per share.
Risk-Reward Ratio: £3 / £16 ≈ 1:5.
This means you're risking £1 to potentially make £5, which is a favorable ratio.
Why This Matters
Understanding support and resistance helps you:
Identify potential reversal points.
Plan your trades with better entry and exit points.
Improve your risk management.