How are Support and Resistance Played in Forex Trading?

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I. Forex Trading Likes a Game

It’s surprising how trading in financial markets resembles a game or even a gamble, but the reality is just that. It’s a battle between two opposing groups of investors – the bulls (longs) who hope for the market to rise and the bears (shorts) who expect it to fall. Both sides fiercely compete to gain control over the market. Sometimes, one side reaps millions in profits while the other prays for the market to turn in their favor.

The forex market, with its trillions of dollars in daily trading volume, operates in this intriguing manner. Just like any game, there are goals, rules, and consequences. Participants must adhere to these rules and strive to outperform their opponents. Success in forex trading also requires strict adherence to rules; violating them doesn’t just lead to market penalties – it fails.

In his book “Deception: My Rogue Trader Career,” author David Brown recounts the scandal at the forex trading desk of the National Australia Bank. The bank incurred a staggering $360 million loss due to inadequate supervision by its executives. Rogue traders opened numerous currency positions, hoping to protect the bank’s assets as the market moved against them. They even averaged down on losing positions (a strategy where new positions are opened in the same direction as the losing trade to lower the average entry price). This approach was popular among stock traders and fund managers in the 1990s. Unfortunately, the exchange rates continued to move against them, causing substantial losses for their clients.

These traders concealed their unethical behaviour, much like guilty children. However, the truth eventually surfaced. One trader, burdened by guilt after realizing the massive floating losses they had caused, confessed everything.

The Australian Securities and Investments Commission (ASIC) intervened, ordering the bank to close all losing positions immediately, resulting in the $360 million loss. Initially, the traders weren’t deemed criminals – just irresponsible. The lack of effective oversight by the bank’s executives led to their downfall. As the investigation continued, many believed that the real culprit was ASIC, as they demanded the bank close all losing positions. Unfortunately, shortly after the losses turned real, the traded currency began to reverse, leaving the bank in a dire situation.

Had these rogue traders remained silent and held their losing positions for another month, their paper losses would have decreased, possibly even turning into millions in profit for the bank. The bank’s executives might have been hailed as heroes instead of facing embarrassment. This legendary tale underscores that in the market, those who adhere to the rules ultimately succeed.

Now, consider this question: “Who exactly trades in the financial markets?”

  • Banks? No.
  • Pension funds? No.
  • Brokers? No.
  • Investment companies? No.
  • Financial institutions? Still no.

The primary actors in financial markets are people – individuals representing various financial organizations. They make decisions that involve millions of dollars based on their thoughts, emotions, and fears.

II. How to Play

The market operates like a game. Bulls and bears constantly battle for control. In the forex market, there are always buyers and sellers. In other words, some become long (buyers), while others join the short (selling) side. Despite both sides having access to the same information, their judgments about market trends diverge. It’s fascinating. While bulls and bears have distinct characteristics, they share one common goal – profiting from the market.

As a trader, understanding this information is crucial. Imagine going long, becoming part of the bullish camp, and seeking an optimal exit point. Ideally, you’d exit just before the market hits a new high. Why? Because once the market reaches new highs, strong pullbacks often follow, potentially erasing your profits.

I’ve received countless calls from traders saying, “I know where to enter, but I don’t know where to exit! After entering, I act like a greedy fool, hoping the market will skyrocket. But unexpectedly, it suddenly reverses to my entry-level, wiping out all my gains.”

Ignorance comes at a cost. Even gamblers are surprised when they lose. Most traders resemble gamblers, hoping luck is on their side.

Few realize that hidden within the casino, there’s a private gambling room where trained experts use their strategies to consistently win thousands or even millions of dollars.

Ignorant traders rely on emotions rather than logic, knowledge, and information as their trading guide – inevitably leading to failure.

III. How Longs and Shorts Profit

Whether you believe it or not, things are often quite simple. Have you ever noticed that the most common things in life are often the easiest to overlook?

Longs (bulls) and shorts (bears) continuously monitor all the highs and lows in the market. When the market creates a new high that surpasses the previous high, the longs score a point. In other words, at this high point, longs make a profit. Following the new high, there is often a market pullback. Conversely, shorts work to drive the market down, consistently creating new lows to profit. Of course, after the new low, a rebound often follows (see the diagram below).

The memory of longs and shorts is as good as an elephant’s—they never forget!

IV. Identify High and Low Points in Forex Trading

A high point occurs when the highest point of a candle’s body or shadow is higher than the highest points of the two adjacent candles. To confirm a high point, check if the candle’s shadow high is lower than the highs of the two candles on its left and right.

The identified high point can serve as a resistance level.
For example, the current resistance level is a high point lower than the previous high point (see the chart below).

A low point occurs when the lowest point of a candle’s body or shadow is lower than the lowest points of the two adjacent candles. To confirm a low point, check if the candle’s shadow low is higher than the lows of the two candles on its left and right.

The identified low point can serve as a support level.
For instance, the current support level is a low point higher than the previous low point (see the chart below).

V. Support and Resistance

Around the clock, seven days a week, bulls and bears vie for control in the market. Bulls strive to keep the market rising, reaching new highs, while bears do the opposite.

Support and Resistance refer to the levels created by the market’s new lows or highs. In the early 20th century, stock traders first introduced these concepts. Here’s how they work:

  1. Support
    Support occurs during a downtrend when traders believe a stock is undervalued and start buying, preventing further decline.
    It’s like a safety net for prices, where demand exceeds supply.
    When support holds, prices tend to bounce back.

  2. Resistance
    Resistance occurs during an uptrend when traders believe prices are too high and stop buying.
    It acts as a ceiling for prices, where supply exceeds demand.
    When resistance holds, prices tend to reverse or consolidate.
    Traders look for these levels to make informed decisions. Whether you’re a bull or a bear, you want to buy low and sell high. This perpetual game of price levels has been ongoing since human trading began, and now we can monitor it using charts.

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