Dynamic Support and Resistance levels
Last updated
Last updated
Dynamic support and resistance mean that support and resistance levels will change their position with a price. The most common dynamic support and resistance levels are Trendlines and Moving Averages.
Trendlines
Trend lines are probably the most common form of technical analysis.
They are probably one of the most underutilized ones as well.
If drawn correctly, they can be as accurate as any other method.
Unfortunately, most forex traders don’t draw them correctly or try to make the line fit the market instead of vice versa.
An uptrend line is drawn along the bottom of easily identifiable support areas (valleys) in their most basic form.
This is known as an ascending trend line.
In a downtrend, the trend line is drawn along the top of easily identifiable resistance areas (peaks).
This is known as a descending trend line.
To draw forex trend lines properly, you must locate two major tops or bottoms and connect them.
What’s next?
Nothing.
Uhh, is that it?
Yep, it’s that simple.
Here are trend lines in action! Look at those waves!
There are three types of trends:
Uptrend (higher lows)
Downtrend (lower highs)
Sideways trend (ranging)
It takes at least two tops or bottoms to draw a valid trend line, but it takes THREE to confirm a trend line.
The STEEPER the trend line you draw, the less reliable it will be and the more likely it will break.
Like horizontal support and resistance levels, trend lines become stronger the more times they are tested.
And most importantly, DO NOT draw trend lines by forcing them to fit the market. If they do not fit right, that trend line isn’t valid!
Moving Averages
Moving averages are one most commonly used technical indicators.
A moving average is simply a way to smooth out price fluctuations to help you distinguish between typical market “noise” and the actual trend direction.
By “moving average,” we mean that you are taking the average closing price of a currency pair for the last ‘X’ number of periods.
On a chart, it would look like this:
As you can see, the moving average looks like a squiggly line overlayed on top of the price (represented by Japanese candlesticks).
This type of technical indicator is called a “chart overlay“.
The moving average (MA) is overlayed on the price chart! Ya dig? 😎
Like every technical indicator, a moving average (MA) indicator is used to help us forecast future prices.
But why not just look at the price to see what’s happening?
The reason for using a moving average instead of just looking at the price is that in the real world, aside from Santa Clause not being real…..trends do not move in straight lines.
Price zigs and zags, so a moving average helps smooth out the random price movements and help you “see” the underlying trend.
By looking at the slope of the moving average, you can better determine the trend direction.
As we said, moving averages smooth out price action.
There are different types of moving averages, each of which has its own " smoothness " level.
Generally, the smoother the moving average, the slower it is to react to the price movement.
The choppier the moving average, the quicker it reacts to the price movement.
To make a moving average smoother, you should get the average closing prices over a longer time period.
The “length” or the number of reporting periods, including the moving average calculation, affects how the moving average is displayed on a price chart.
The shorter its “length”, the fewer the data points that are included in the moving average calculation, which means the closer the moving average stays to the current price.
This reduces its usefulness and may offer less insight into the overall trend than the current price itself.
The longer its length, the more data points are included in the moving average calculation, which means the less any single price can affect the overall average.
If there are too many data points, price fluctuations may become “too smooth” that you won’t be able to detect any trend!
Either situation can make it difficult to recognize if price direction may change in the near future.
For this reason, it’s important to select the length (or periods) that provides the level of price detail appropriate for your trading timeframe.
You’re probably thinking, “C’mon, let’s get to the good stuff. How can I use this to trade?”
In this section, we first need to explain to you the two major types of moving averages:
Simple
Exponential
Before we move on, remember that moving averages smooth price data to form a trend-following technical indicator.
They do NOT predict price direction; instead, they define the current direction with a lag.
A simple moving average (SMA) is the simplest type of moving average.
Basically, a simple moving average is calculated by adding up the last “X” period’s closing prices and then dividing that number by X.
Confused???
Don’t worry; we’ll make it crystal clear.
If you plotted a 5-period simple moving average on a 1-hour chart, you would add up the closing prices for the last 5 hours and divide that number by 5.
Voila! You have the average closing price over the last five hours! String those average prices together, and you get a moving average! If you were to plot a 5-period simple moving average on a 30-minute chart, you would add up the closing prices of the last 150 minutes and then divide that number by 5.
If you were to plot the 5-period simple moving average on the 4 hr. charts… Okay, okay, we know, we know. You get the picture!
Most charting packages will do all the calculations for you.
We just bored you (yawn!) with a “how-to” on calculating simple moving averages because it’s important to understand so that you know how to edit and tweak the indicator.
Understanding how an indicator works means you can adjust and create different strategies as the market environment changes.
Now, as with almost any other forex indicator out there, moving averages operate with a delay.
Because you are taking the averages of past price history, you are really only seeing the general path of the recent past and the general direction of “future” short-term price action.
Disclaimer: Moving averages will not turn you into Ms. Cleo, the psychic!
Here is an example of how moving averages smooth out the price action.
On the chart above, we’ve plotted three different SMAs on the 1-hour chart of USD/CHF. As you can see, the longer the SMA period is, the more it lags behind the price.
Notice how the 62 SMA is farther away from the current price than the 30 and 5 SMAs.
This is because the 62 SMA adds up the closing prices of the last 62 periods and divides it by 62.
The longer period you use for the SMA, the slower it is to react to them.
The SMAs in this chart show you the market's overall sentiment at this point in time. Here, we can see that the pair is trending.
Instead of just looking at the market's current price, the moving averages give us a broader view, and we can now gauge the general direction of its future price.
Using SMAs, we can tell whether a pair is trending up, trending down, or just ranging.
There is one problem with the simple moving average: they are susceptible to spikes.
When this happens, this can give us false signals. We might think a new currency trend may develop, but nothing has changed.
In the next lesson, we will show you what we mean and introduce you to another moving average to avoid this problem.
As we said in the previous lesson, spikes can distort simple moving averages. We’ll start with an example.
Let’s say we plot a 5-period SMA on the daily chart of EUR/USD.
The closing prices for the last five days are as follows:
Day 1: 1.3172
Day 2: 1.3231
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293
The simple moving average would be calculated as follows:
Simple enough, right?
What if a news report on Day 2 caused the euro on the board?
This caused/USD to plunge and close at 1.3000. Let’s see what effect this would have on the 5-period SMA.
Day 1: 1.3172
Day 2: 1.3000
Day 3: 1.3164
Day 4: 1.3186
Day 5: 1.3293
The simple moving average would be calculated as follows:
The result of the simple moving average would be a lot lower and give you the notion that the price was going down when in reality, Day 2 was just a one-time event caused by the poor results of an economic report.
We’re trying to point out that the simple moving average might sometimes be too simple.
If only there were a way to filter out these spikes so that you wouldn’t get the wrong idea.
Hmm… Wait a minute… Yep, there is a way!
It’s called the Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods.
In our example above, the EMA would put more weight on the prices of the most recent days, which would be Days 3, 4, and 5.
This would mean that the spike on Day 2 would be of lesser value and wouldn’t have as big an effect on the moving average as it would if we had calculated for a simple moving average.
If you think about it, this makes a lot of sense because what this does is it puts more emphasis on what traders have been doing recently.
Let’s look at the 4-hour chart of USD/JPY to highlight how a simple moving average (SMA) and exponential moving average (EMA) would look side by side on a chart.
Notice how the red line (the 30 EMA) seems to be a closer price than the blue line (the 30 SMA).
This means that it more accurately represents recent price action. You can probably guess why this happens.
It’s because the exponential moving average emphasizes what has been happening lately.
It is far more important to see what traders are doing now than what they did last week or month.
By now, you’re probably asking yourself, which is better?
The simple or the exponential moving average?
First, let’s start with the exponential moving average.
When you want a moving average that will respond to the price action rather quickly, then a short-period EMA is the best way to go.
These can help you catch trends early (more on this later), resulting in higher profit. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits (boo yeah!).
The downside to using the exponential moving average is that you might get faked out during consolidation periods (oh no!).
Because the moving average responds so quickly to the price, you might think a trend is forming when it could just be a price spike. This would be a case of the indicator being too fast for your own good.
With a simple moving average, the opposite is true.
When you want a smoother moving average and slower to respond to price action, a longer period SMA is the best way to go.
This would work well when looking at longer time frames, as it could give you an idea of the overall trend.
Although it is slow to respond to the price action, it could possibly save you from many fake outs.
The downside is that it might delay you too long, and you might miss out on a good entry price or the trade altogether.
An easy analogy to remember the difference between the two is to think of a hare and a tortoise.
The tortoise is slow, like the SMA, so you might miss out on getting in on the trend early.
However, it has a hard shell to protect itself, and similarly, using SMAs would help you avoid getting caught up in fakeouts.
On the other hand, the hare is quick, like the EMA. It helps you catch the beginning of the trend, but you risk getting sidetracked by fakeouts (or naps if you’re a sleepy trader).
Below is a table to help you remember the pros and cons of each.
PROS
Displays a smooth chart that eliminates most fakeouts.
Quick Moving and is good at showing recent price swings.
CONS
Slow-moving, which may cause a lag in buying and selling signals
More prone to cause fakeouts and give errant signals.
So which one is better?
With moving averages generally, the longer the period, the slower it is to react to price movement.
But with all else being equal, an EMA will track price more closely than an SMA.
Because of this, the exponential moving average is typically considered more appropriate for short-term trading.
The same attributes that make the EMA more suited for short-term trading limit its effectiveness in longer-term trading.
Since the EMA will move with price sooner than the SMA, it often gets whipsawed, making it less than ideal for triggering entries and exits on “slower” chart timeframes like daily (or longer).
With its slower lag, the SMA tends to smooth price action over time, making it a good trend indicator, allowing it to remain long when the price is above the SMA and short when it is below the SMA.
So SMA or EMA? It’s really up to you to decide.
You don’t have to limit yourself to a single type of MA or a single instance of an MA.
Many traders plot different moving averages to give them both sides of the story.
They might use a longer period simple moving average to find out the overall trend and a shorter period exponential moving average to find a good time to enter a trade.
Several trading strategies are built around the use of moving averages. In the following lessons, we will teach you:
How to use moving averages to determine the trend
How to use multiple moving averages together
How moving averages can be used as dynamic support and resistance
One sweet way to use moving averages is to help you determine the trend.
The simplest way is to plot a single moving average on the chart.
When price action stays above the moving average, the price is generally UPTREND.
If price action stays below the moving average, it indicates it is in a DOWNTREND.
The problem with this is that it’s too simplistic.
Suppose USD/JPY has been in a downtrend, but a news report comes out, causing it to surge higher.
You see that the price is now ABOVE the moving average. You think to yourself:
“Hmmm… It looks like this pair is about to shift direction. Time to buy this suckerrrr!”
So you do just that. You buy a billion units cause you’re confident that USD/JPY will increase.
Bam! You get faked out!
As it turns out, traders just reacted to the news, but the trend continued, and the price kept heading lower!
What some traders do, and what we suggest you do as well, is that they plot a couple of moving averages on their charts instead of just ONE.
This gives them a clearer signal of whether the pair is trending up or down depending on the order of the moving averages.
Let us explain.
In an uptrend, the “faster” moving average should be above the “slower” moving average, and for a downtrend, vice versa.
For example, let’s say we have two MAs: the 10-period MA and the 20-period MA. On your chart, it would look like this:
Above is a daily chart of USD/JPY.
Throughout the uptrend, the 10 SMA is above the 20 SMA.
As you can see, you can use moving averages to help show whether a pair is trending up or down.
Combining this with your knowledge of trend lines can help you decide whether to go long or short a currency pair.
So far, you have learned how to determine the trend by plotting moving averages on your charts.
You should also know that moving averages can help you determine when a trend is about to end and reverse.
As trend traders, you want to recognize and ride the trend for as long as possible.
You have to know when to get in AND when to get out.
A trend can be defined simply as the general direction of the price over the short, immediate, or long-term.
Some trends are short-lived, while others last for days, weeks, or months.
But you don’t necessarily know how long a specific trend will last.
A technical tool known as a moving average crossover can help you identify when to get in and out.
A moving average crossover occurs when two different moving average lines cross.
Because moving averages are a lagging indicator, the crossover technique may not capture exact tops and bottoms. But it can help you identify the bulk of a trend.
A moving average crossover system helps to answer these three questions:
Which direction might the price be trending (if at all)?
Where might be a potential entry point for a trend trade?
When might a trend be ending or reversing?
All you have to do is plop on a couple of moving averages on your chart and wait for a crossover.
If the moving averages cross over one another, it could signal that the trend is about to change soon, thereby giving you a chance to get a better entry.
Let’s .look at that daily chart of USD/JPY to help explain moving average crossover trading.
From around April to July, the pair was in a nice uptrend. It topped out at around 124.00 before slowly heading down. In the middle of July, we saw that the 10 SMA crossed below the 20 SMA.
And what happened next?
A nice downtrend!
If you had shorted at the crossover of the moving averages, you would have made almost a thousand pips!
Of course, not every trade will be a thousand-pip winner, a hundred-pip winner, or even a 10-pip winner.
It could be a loser, meaning you must consider where to place your stop loss or when to take profits. You can’t jump in without a plan!
What some traders do is that they close out their position once a new crossover has been made or once the price has moved against the position of a predetermined amount of pips.
This is what Huck does in her HLHB system. She either exits when a new crossover has been made or has a 150-pip stop loss, just in case.
This is because you don’t know when the next crossover will be. You may end up hurting yourself if you wait too long!
One thing to note with a crossover system is that while they work beautifully in a volatile and trending environment, they don’t work well when the price ranges.
You will get hit with tons of crossover signals, and you could find yourself getting stopped out multiple times before you catch a trend again.
In summary, moving average crossovers help identify when a trend might be emerging or when a trend might be ending.
The crossover system offers specific triggers for potential entry and exit points.
Another way to use moving averages is to use them as dynamic support and resistance levels.
We call it dynamic because it’s unlike your traditional horizontal support and resistance lines. They are constantly changing depending on recent price actions.
Many forex traders look at these moving averages as key support or resistance. These traders will buy when the price dips and tests the moving average or sell if the price rises and touches the moving average.
Look at the 15-minute chart of GBP/USD and pop on the 50 EMA. Let’s see if it serves as dynamic support or resistance.
It looks like it held well! Every time price approached 50 EMA and tested it, it acted as resistance, and the price bounced back down. Amazing, huh?
One thing you should keep in mind is that these are just like your normal support and resistance lines.
The price won’t always bounce perfectly from the moving average. Sometimes it will go past it a little bit before heading back in the direction of the trend.
There are also times when the price will blast past it altogether. Some forex traders pop on two moving averages and only buy or sell once the price is in the middle of the space between the two moving averages.
You could call this area “the zone.”
Let’s take another look at that 15-minute chart of GBP/USD, but this time let’s use the 10 and 20 EMAs.
From the chart above, you see that price went slightly past the 10 EMA a few pips but proceeded to drop afterward.
Some traders use intraday strategies just like this.
The idea is that the averages shouted like zones or areas of interest, like your horizontal support and resistance areas.
The area between moving averages could be considered a support resistance zone.
Now you know that moving averages can potentially act as support and resistance. Combining a couple, you can have a nice little zone.
But you should also know they can break, like any support and resistance level!
Look at the 50 EMA on GBP/USD’s 15-minute chart.
The chart above shows that the 50 EMA held a strong resistance level for a while as GBP/USD repeatedly bounced off it.
However, as highlighted in the red box, the price finally broke through and shot up.
Price then retraced and tested the 50 EMA again, which proved to be a strong support level.
So there you have it, folks!
Moving averages also act as shows support and resistance levels. One nice thing about using moving averages is that they’re always changing, meaning you can leave it on your chart and don’t have to keep looking back in time to spot potential support and resistance levels.
You know that the line most likely represents a moving area of interest. The only problem is figuring out which moving average to use!
What is a moving average ribbon?
A moving average ribbon is a series of moving averages of different lengths plotted on a chart.
The basic idea behind the concept of “moving average ribbons” is that instead of using one or two moving averages on a chart, you are using a bunch of moving averages, usually between 6 to 16 moving averages (or more).
All are on the same chart.
Let’s take a look at an example…
Traders can determine the strength of a trend by looking at the smoothness of the ribbon and identify key areas of support or resistance by looking at the price in relation to the ribbon.
A common question is, “How many moving averages do I use?”
It really depends on the trader.
Some traders like to use six to eight simple moving averages (SMA) set at 10-period intervals, such as the 10, 20, 30, 40, 50, and 60-day SMAs.
Other traders like to set up with SIXTEEN (or more) simple moving averages varying from a 50-day to a 200-day SMA and everything in between.
The argument for using longer-term MAs is that it gives a more accurate look at the overall trend.
Then other traders like to use exponential moving averages instead of simple moving averages.
So it’s really a matter of preference.
The responsiveness of the moving average ribbon can be adjusted by:
Changing the number of time periods used in the moving average
Changing the moving average from a simple moving average (SMA) to an exponential moving average (EMA)
The shorter the number of periods used when selecting which MAs to add to your chart, the more sensitive the moving average ribbon is to slight price changes.
Moving averages with larger periods (like 200) are less sensitive and smoother.
When the moving averages start widening out and separating, also known as ribbon “expansion”, this signals that the recent price direction has reached an extreme and could end a trend.
Think of each moving average as a magnet and they’re attracted to each other.
They do not want to be too far apart from each other for too long. So when they are, they will want to close that distance.
When the moving averages start to converge and get closer to each other, also known as ribbon “contraction,” a trend change has possibly started.
After an extreme move in price in one direction, you will notice shorter-term moving averages converge first. The longer-term moving averages will slowly converge.
When the moving average ribbons are parallel and evenly spaced, this means that the current trend is strong.
All the moving averages are in “agreement” since they move together.
Some traders make the mistake of only paying attention when the moving averages “cross over” or “twist”.
While monitoring when the short-term moving averages cross above (or below), the long-term moving averages is important, it’s also important to monitor the SPACING between them.
The positioning of short-term moving averages relative to long-term moving averages shows the DIRECTION of the trend (down, neutral, up).
The spacing between the moving averages shows the trend's STRENGTH (weak, neutral, strong).
Let’s take a look at a moving average ribbon applied to GBP/USD on a 1-hour chart.
Can you see the trend changes?
In the chart above, you can easily identify bullish or bearish trends by looking at when the moving averages start to cross over or “twist” lower or higher.
Ribbon expansion or the widening of spacing between the moving averages suggests the end of the current trend.
Ribbon contraction, or the narrowing of spacing between the moving averages, suggests starting a new trend.
