A clear understanding of the terms support and resistance levels helps in identifying key investment levels. These levels refer to key levels on the charts that act as barriers from preventing the price of a currency or an asset either breaking above or below. The resistance levels act as a ceiling by preventing a further rise in the prices while the support prices act as a floor by preventing the price of an asset from falling further.
Thus, we as traders are looking to place our entries near these key levels, so once you are able to identify them, you can improve your accuracy and hit rate by getting in where the institutional players are.
But it is important to understand how price action has reacted to these levels in the past. A strong reaction to a level increases the chances that traders expect a similar reaction when the price approaches that level the next time.
A classic example of understanding this is analyzing the movement in gold prices. Gold witnessed a very strong uptrend in 2011, rising to a level of $1900 an oz.
However, gold started an aggressive and impulsive sell-off, by almost $200 in just three days. The next time this uptrend was approached this same $1900 level, it was followed by a sell off and decline in prices of $200 an oz.
However, this time the decline was spread over a period of 13 days. So violent reactions to any level are an indicator that one should place a trade at that level expecting it to hold and result in similar but restrained reaction as seen in the chart below.
Apart from considering the strength of the reaction of traders to a particular level, you will also need to check whether the particular level resulted in a breakout pullback setup. Another thing to consider is whether it had held for several times in the past, and how much was invested or spent at those levels.
Apart from seeing the past behavior we also need to look at the current price action. One needs to gather information about how the market is behaving now and this will help in judging whether the trend is likely to continue or a breakout is expected.
So you need to check the history and the performance of the market at a key level besides considering the current price action to judge whether the level is a resistance and support level. This will greatly help you to make more accurate and profitable trades.