Understanding technical analysis gives you the edge as a forex trader. It develops your confidence in your analysis of what will happen in the markets in the future.
But the most important setback with most of the technical indicators is that they are always lagging behind the markets. Lag means some of the price action has already taken place before the movement is reflected by these technical indicators.
However, support and resistance levels especially those calculated based on Fibonacci levels are considered to be leading indicators of the price action. They lead the markets in predictable paths. Now, when we are saying predictable, it does not mean 100% guaranteed, but these levels can be pretty close.
Support is the price level that a currency pair has trouble breaking through to the downside. Support is also referred to as the floor of the currency pair price movement.
Resistance is the price level that a currency pair touches but has trouble breaking through to the upside. Resistance level is also called the ceiling of the currency pair price movement.
Many new forex traders find it surprising that there is a strangely predictable and reliable price action that takes place at the support and resistance levels. Most of the time, they will find the price action oscillating between the support and resistance levels.
Why it is so that majority of the traders begin buying and selling at the given support and resistance levels. There is nothing on the charts that forces the forex traders to do so.
The simplest explanation one can give is this that majority of the currency traders think the support level as the best price available and considers it an excellent opportunity to go long once it reaches the support level.
Similarly, at resistance, majority of the traders think that currency pair is not favorably priced and has reached its highest price. So they consider it as an excellent opportunity to sell the currency pair.
You will have an edge and an advantage in your currency trading if you are capable of accurately identifying and predicting the support and resistance levels in the markets. As more and more traders use technical analysis in trading and calculate the support and resistance levels, the more these levels become self fulfilling prophesies.
One important characteristic of support and resistance levels is that the price level is reached a number of times but a breakout never takes place and is never breached. Support and resistance levels are horizontal for a ranging markets and they can be sloping up or down for a trending market.
What happens at the support level is that as traders begin to sell the currency pair and take profit, the price of the currency pair starts to drop down. As the price starts to fall, other forex traders who were interested in buying the currency pair watch how far it will go down.
Most of them have done their calculations as to how far the price level will fall down before they can place a buy order. Past price action has convinced them the price offered at the support level is the best price under the present market conditions. So when it reaches that level, most of them start buying.
When there are more buyers than sellers in the market, the price of the currency pair starts to rebound and rise. It rises till the resistance level determined by most of them when majority decide that the currency pair is now over priced and start selling.
This oscillating price action keeps on repeating itself and the support and resistance levels are seldom breached until and unless there is a fundamental change in the markets that forces new levels and a new direction.
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