Imagine that a currency pair has been trading between two levels, a support at the bottom of the price range, and a resistance level at the top. When the price is rising off a support level, they would be thinking like this –

• The longs are congratulating themselves on being smart traders, and wishing they’d bought more as they would have been able to make more of a killing. They may be thinking that they will buy more if the price goes back down to that level.
• The shorts are thinking that they may be wrong, and are hoping for the price to drop back down. If it does, then at least they can buy to cover their position, and get out of the trade without losing so much.
• The undecideds are thinking that they may have missed the boat by hesitating, and lost out on a winning trade. They make their minds up that they will buy shares if the price should come back down, and not miss out a second time.

So all three groups are looking at the support level, and deciding to buy if the price comes back down to it. While this is an oversimplification of the psychological complexity of trading, you can see where the logic of this is leading. The demand for shares by all three market participants will, by the laws of supply and demand, force the falling price to reverse and go back up. This explains why a support level can work so well and so often.

What if this does not take place? Perhaps for their own reasons some of the market participants are not convinced, and so the demand is not sufficient to keep the price up. 

What if the price falls through the support level? Suddenly, as they realize that the price isn’t stopping and reversing at the support level, everyone’s reaction will change. The thought patterns will be modified, so that –

• The longs think they must have made a mistake. Depending how far the price falls, the longs may decide to accept their loss by selling up and closing the trade. But it is hard to do that, so they may hang on to see if they can sell at the support level, if the price comes back up.
• The shorts are congratulating themselves on anticipating the market move correctly. They may be wishing that they had taken a larger short position, and thinking that if the price goes back up to the support level, maybe they’ll short (sell) some more shares.
• The undecided’s think that now they have missed out on shorting the shares, and may be kicking themselves for being so indecisive. This time they may resolve to sell short some shares if the price would only come back up to the old support level.

So suddenly, instead of buying at the old support level, and thus making the price bounce back up, everyone is thinking of selling if the price gets back up there. If they all do that, the laws of supply and demand say that the price will go down. The old support becomes the new resistance, not by magic but by human nature.

You can see how you can apply exactly the same type of logic to a resistance level. Again, once it is distinctly broken, and the market participants accept that fact, their view of the level changes and it becomes a new support. Technical analysis is a study of human nature more than a mechanistic process.

There are a couple of ways that you can determine how solid the levels are, and therefore how likely they are to hold whenever they are tested. They are based on common-sense, for the most part.

• You can start by looking at how often the price has gone to the level and bounced off. If it has happened several times, then it is more solid than if it has only been touched once, for instance. Incidentally, if there are several touches it also makes the level easier to determine and helps in your analysis.
• Another factor is how long the currency pair price has been trading in that vicinity. If it’s only been there for a couple of days, then the support or resistance level is not so solid or established if it has been around there for a few months.
• A third factor is how recently that level has been visited. Every time the level is reached, and holds strong, we say that level has been “tested”, and if it has been tested and held recently then it is more likely to hold up to further testing.
• You should make sure that you check the amount of trading volume that happened when the level was reached. Any time you see a lot of volume, you can be sure that you are getting the majority vote of the market. On the other hand, if there is a light volume of trading, that should make you cautious of what the prices are telling you. Volume is an important part of the data available to you, so you must be sure not to make the mistake of looking only at the price action.
• Finally, as mentioned above the support and resistance levels tend to be around whole numbers. So the obvious conclusion is that if the support or resistance you are considering is around a whole number, it is likely to be stronger and to hold for more times or for a longer period. These are all factors you should consider when you are gauging how much dependency you can place in on the levels of support and resistance that you have observed.

You should note that if you want to get out of the trade because you think it is coming up to a resistance level, or dropping down to a support level, you must keep this whole number thing in mind. If you really want to close your trade it’s worth doing so just before the whole number is reached, just to make sure that it happens. You should place your order to get out just before the whole number so you can be more sure it will take place. Given the variability of trading, you might find that the number is not quite touched and you will be left in your trade as the price rebounds, taking away your profit.