Trading rules based on supports and resistances
A support or resistance that stood at least three times can be considered as a strong one.
Since these trading rules depend on the strength of supports and resistances, let us look at that first. There are several methods to measure the strength of supports and resistances. The first method is to see how many times the price hit these levels and failed to break it. This is because each time the bears and bulls fail to penetrate a support or resistance level, they become less optimistic about breaking it in future. A support or resistance that stood at least three times can be considered as a strong one.
Round numbers (e.g. stock crossing Rs 1,000 mark) are also strong supports and resistances. This will be similar to the excitement it will generate when the Sensex crosses the 40,000 mark. The round numbers act as resistance because bears start to sell when price moves towards round numbers, making it difficult for the price to cross these levels. Similarly, buyers usually purchase large quantities when the price starts coming down to some major round number, which makes it difficult for the price to fall below that level. And as is visible from the Nifty Chart, you can see that the 10,000 level has acted as strong support two times (marked as the two upward arrows).
As mentioned earlier, trading is possible only close to strong support or resistance levels; therefore, investors should be extra vigilant when the share price drifts close to any of them. The normal trading strategy is to buy (or go long) close to the strong support levels (and place a stop loss at the support level) and sell (or go short) close to the strong resistance levels (and place a stop loss at the resistance level). As explained earlier, traders would have generated good returns if they had initiated long positions when the Nifty came back close to 10,000 levels.
Next trading strategy is based on the breakdown of support or resistance levels, because this signals that the existing relationship between supply and demand has changed. The price moving above the strong resistance level, which is known as a breakout, is a buy signal because it indicates that the demand has gained the upper hand.
So the strategy should be to buy once a support is taken out decisively (with enough trading volume, too) and place a stop loss at the resistance level that was just broken. Similarly, the stock price falling below a strong support level, which is known as a breakdown, means that the supply has won the battle and therefore, it’s a sell signal. As visible from the Yes Bank chart, the counter got strong support close to Rs 280 levels (the upward arrow in the chart) and a decisive breakdown of that played havoc in the counter. And as per the role reversal rule, the same Rs 280 level also acted as resistance when it came back there (marked as downward arrow in the chart).