Combining Fibs with Support and Resistance

Like we said in the previous section, using Fibonacci levels can be very subjective. However, there are ways that you can help tilt the odds in your favor.

While the Fibonacci tool is extremely useful, it shouldn't be used all by its lonesome self.

It's kinda like comparing it to NBA superstar Kobe Bryant. Kobe is one of the greatest basketball players of all time, but even he couldn't win those titles by himself. He needs some backup.

Similarly, the Fibonacci tool should be used in combination with other tools. In this section, let's take what you've learned so far and try to combine them to help us spot some sweet trade setups.

Are y'all ready? Let's get this pip show on the road!

One of the best ways to use the Fibonacci tool is to spot potential support and resistance levels and see if they line up with Fibonacci retracement levels.

If Fib levels are already support and resistance levels, and you combine them with other price areas that a lot of other traders are watching, then the chances of price bouncing from those areas are much higher.

Let's look at an example of how you can combine support and resistance levels with Fib levels. Below is a daily chart of USD/CHF.

As you can see, it's been on an uptrend recently. Look at all those green candles! You decide that you want to get in on this long USD/CHF bandwagon.

But the question is, "When do you enter?" You bust out the Fibonacci tool, using the low at 1.0132 on January 11 for the Swing Low and the high at 1.0899 on February 19 for the Swing High.

Now your chart looks pretty sweet with all those Fib levels.

Now that we have a framework to increase our probability of finding solid entry, we can answer the question "Where should you enter?"

You look back a little bit and you see that the 1.0510 price was good resistance level in the past and it just happens to line up with the 50.0% Fib retracement level. Now that it's broken, it could turn into support and be a good place to buy.

If you did set an order somewhere around the 50.0% Fib level, you'd be a pretty happy camper!

There would have been some pretty tense moments, especially on the second test of the support level on April 1. Price tried to pierce through the support level, but failed to close below it. Eventually, the pair broke past the Swing High and resumed its uptrend.

 You can do the same setup on a downtrend as well. The point is you should look for price levels that seem to have been areas of interest in the past. If you think about it, there's a higher chance that price will bounce from these levels.

Why?

First, as we discussed in Grade 1, previous support or resistance levels would be good areas to buy or sell because other traders will also be eyeing these levels like a hawk.

Second, since we know that a lot of traders also use the Fibonacci tool, they may be looking to jump in on these Fib levels themselves.

With traders looking at the same support and resistance levels, there's a good chance that there are a ton of orders at those price levels.

While there's no guarantee that price will bounce from those levels, at least you can be more confident about your trade. After all, there is strength in numbers!

Remember that trading is all about probabilities. If you stick to those higher probability trades, then there's a better chance of coming out ahead in the long run.

Support and Resistance

Support and resistance is one of the most widely used concepts in trading. Strangely enough, everyone seems to have their own idea on how you should measure support and resistance.

Let's take a look at the basics first. 

Look at the diagram above. As you can see, this zigzag pattern is making its way up (bull market). When the market moves up and then pulls back, the highest point reached before it pulled back is now resistance.

As the market continues up again, the lowest point reached before it started back is now support. In this way resistance and support are continually formed as the market oscillates over time. The reverse is true for the downtrend.

Plotting Support and Resistance

One thing to remember is that support and resistance levels are not exact numbers.

Often times you will see a support or resistance level that appears broken, but soon after find out that the market was just testing it. With candlestick charts, these "tests" of support and resistance are usually represented by the candlestick shadows.

Notice how the shadows of the candles tested the 1.4700 support level. At those times it seemed like the market was "breaking" support. In hindsight we can see that the market was merely testing that level.  

So how do we truly know if support and resistance was broken?

There is no definite answer to this question. Some argue that a support or resistance level is broken if the market can actually close past that level. However, you will find that this is not always the case.

Let's take our same example from above and see what happened when the price actually closed past the 1.4700 support level.

In this case, price had closed below the 1.4700 support level but ended up rising back up above it.

If you had believed that this was a real breakout and sold this pair, you would've been seriously hurtin'!

Looking at the chart now, you can visually see and come to the conclusion that the support was not actually broken; it is still very much intact and now even stronger.

To help you filter out these false breakouts, you should think of support and resistance more of as "zones" rather than concrete numbers.

One way to help you find these zones is to plot support and resistance on a line chart rather than a candlestick chart. The reason is that line charts only show you the closing price while candlesticks add the extreme highs and lows to the picture.

These highs and lows can be misleading because often times they are just the "knee-jerk" reactions of the market. It's like when someone is doing something really strange, but when asked about it, he or she simply replies, "Sorry, it's just a reflex."

When plotting support and resistance, you don't want the reflexes of the market. You only want to plot its intentional movements.

Looking at the line chart, you want to plot your support and resistance lines around areas where you can see the price forming several peaks or valleys.

Other interesting tidbits about support and resistance:

• When the price passes through resistance, that resistance could potentially become support.
• The more often price tests a level of resistance or support without breaking it, the stronger the area of resistance or support is.
• When a support or resistance level breaks, the strength of the follow-through move depends on how strongly the broken support or resistance had been holding.

With a little practice, you'll be able to spot potential support and resistance areas easily. In the next lesson, we'll teach you how to trade diagonal support and resistance lines, otherwise known as trend lines.