How to Draw Support and Resistance Lines

Are chart analysts choosing random points to make these lines or is there a method to their madness?

In today's article I'm going to answer a very famous, and often unanswered, question regarding technical chart reading.

Before we go any further, it would do you good to read any previous articles that I've written or co-written, as this article more or less assumes that you have. That being said, I'd love to clear up a very famous question:

"How do you know where to draw support/resistance lines?"

And before answering this, I'm going to assume that you already have a basic knowledge of candlestick charts or more specifically, that you can discern the high, low, opening and closing prices of a candlestick on a chart. If you are not familiar with these concepts then don't worry - you'll find a plethora of information on candlesticks via Google.

OKAY. First of all, professionals that draw support and resistance lines all have their own personal preferences. So rather than just telling you mine, I prefer to teach you to find your own personal style. Below is a chart with two support lines placed by the most prominent, and useful, methods of delineating support and resistance lines:

One school of thought likes to base Support and Resistance (also known as S/R) Lines on the 'bodies' of the candles. Support Line #1 was made based on this theory. The other major school, and most common, bases support or resistance lines on the utter extremes - the lowest low or the highest high - as in Support Line #2.

There are advantages and disadvantages to both. For example, because Support Line #1 was based on the bodies of the candles, and not the extremes, you get a 'tighter' line that triggers signals earlier - because price action will always penetrate a low based on the body BEFORE penetrating an extreme. In this chart you'll notice that Support Line #1 was later penetrated three times by lows (the first one being the immediate candle after, the next one being 3 candles after that and the third one being 4 candles/hours after that), but none of them led to a downward trend. Even further, after the first time an entire candle (meaning ALL of it, including its high and low) appears below the line, a downward trend STILL does not follow. Instead prices climbed a bit leaving you with a grand total of FOUR false signals.

Support Line #2 was ALSO penetrated three times (much later - it's the three adjacent candles beginning with the one that was labeled, "First time an entire candle penetrates Support Line #1"), but all three times price climbed. However, after the first time an entire candle appears below Support Line #2, prices drop like a rock. Now you might be thinking that using ONLY extreme highs and lows should be the way to go and you're definitely right in THIS particular example, but sometimes measuring by the bodies is better. It's really up to you, though, because when you really look at the big picture, both methods speak the truth:

1. Measuring by the bodies can give earlier signals, but more false ones too; and

2. Measuring by extreme highs and lows gives less signals but more accurately albeit sometimes late.

Either way, prices DID tend to respond to both lines with enough 'general accuracy' and that's all we really care about when studying charts for the medium term or the long haul.

Okay I'm almost done here. Finally, there are two more factors that may affect your decision at any given moment as to which method to use:

1. TIME - What if you have a ton of S/R lines and don't know which to trust? In this case, often times the more recent line holds more weight than lines based on much older prices. HOWEVER, lines based on longer time frames (like charts whereby each candlestick represents a day, a week or even an entire month) should not be completely forgotten.

2. QUANTITY - What if you have chosen to go by the extreme highs and lows of candles, but notice that recently, there have been a LOT of coinciding bodies that would share the exact same S/R line? In these cases we found that basing the S/R line on the method that has the most number of candles supporting it should take precedence. This isn't, however, always true as you can see from the above chart example we gave here where, although the 'bodies' method was based on the occurrence of two candlesticks, it gave more false signals than the one candle used for the 'extreme low' method.

Whichever of the two above factors you use when choosing an S/R line, just know that the TIME factor is usually much more important than the QUANTITY factor.

So there you have it. I know some of you were probably expecting me to lay out an exact science that just tells you what to do. However, when they say that chart-reading is not just a science, but an art as well, I think you should understand now that I have provided you with the canvas, paint and brush. The rest is up to you and your wrist.

Remember, technical charts are not maps that pinpoint exactly where prices will be, they are more like archaic GPS devices accurate to within a mile...

- Gerald

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