What is support and resistance you ask? Support and resistance are fundamental ideas in technical analysis. They help us read price charts accurately.
Prices change because of supply and demand. When more people want to buy than sell, prices go up. When more people want to sell than buy, prices go down. Sometimes, prices stay the same when both supply and demand are balanced.
While these ideas are straightforward, becoming skilled at using them in real trading can take a lot of practice.
| What is support and resistance: Highlights |
|---|
| Technical analysts use support and resistance levels to spot points on a chart where a trend might stop or change. |
| Support: This happens when a falling trend might stop because there’s a lot of demand. |
| Resistance: This occurs when a rising trend might temporarily pause because there’s a lot of supply. |
| Market psychology plays a big role, as traders and investors think about past experiences and react to new conditions to guess what might happen next. |
| Support and resistance areas can be seen on charts using lines that show trends and averages of prices. |
What you'll learn:
β€ What Is Support?
In a downtrend, prices fall because there are more people selling than buying. The lower the prices go, the more attractive they become to those waiting to buy. Eventually, the demand for buying matches the supply of selling, and prices stop falling. This is what we call support.
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Support can be a specific price level on a chart or a price zone. It’s a place on the chart that shows where buyers are willing to buy. At this point, demand becomes stronger than supply, causing the price to stop falling and often reverse its direction.
β€ What Is Resistance?
Resistance is the opposite of support. Prices go up because there are more people wanting to buy than sell. As prices rise, there comes a point when selling becomes stronger than buying. This can happen for various reasons, like people thinking prices are too high or not wanting to buy more at that price.
On a price chart, you’ll clearly see a level where supply starts to beat demand. This is resistance, and like support, it can be a specific level or an area.
Once we identify a support or resistance area, these price levels can be used as potential entry or exit points. When the price reaches a previous support or resistance level, it typically does one of two things: either it bounces back from that level, or it breaks through and continues its previous direction until it reaches the next support or resistance level.
Some traders make trades based on the belief that support and resistance zones will hold. Whether the price stops at or breaks through these levels, traders can make a quick decision on the price’s direction.
If it goes the wrong way (breaking previous support or resistance), they might close the trade with a small loss. But if it goes the right way (respects previous support or resistance), it could lead to a significant gain.
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β€ Support and Resistance Basics
Support and resistance are not limited to specific timeframes; they can be observed on daily, weekly, and monthly charts. Traders also spot them on smaller timeframes like one-minute and five-minute charts. However, the longer the timeframe, the more significant the support or resistance tends to be.
To identify these levels, you need to look back at the chart to find moments when prices paused significantly during either a rise or a fall. Then, you should look forward to see if prices halt or reverse as they approach these points. Many experienced traders pay close attention to past support or resistance levels, using them as cues for future price reactions.
It’s important to note that technical analysis isn’t an exact science. Sometimes, prices may dip below support levels or reverse before reaching them, just as they might do with resistance levels. Interpretation of chart patterns requires flexibility, which is why these levels are often referred to as zones.
These price levels aren’t magical; they simply reflect the fact that many traders act based on the same information and place trades at similar levels.
Experienced traders often have stories about prices stalling at specific levels. For instance, imagine Jim holding a stock position from March to November, expecting its value to rise. He might notice that despite coming close, the price fails to surpass $39 multiple times over several months.
In this case, traders would call the level near $39 a resistance level. As shown in the chart below, resistance levels are like ceilings, where price rallies tend to lose momentum.
On the other hand, support levels represent equilibrium on a chart. This is where demand matches supply, causing a halt in the price decline. It’s essentially a price floor. As depicted in the chart below, the horizontal line under the price represents this floor.
The blue arrows below the vertical line show that the price has touched this level four times in the past. This is where demand steps in, preventing further drops. This is support.
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β€ Trendlines Basics
Certain price levels act as barriers, preventing an asset’s price from going higher or lower. These stable barriers are some of the most commonly known forms of support and resistance.
However, the prices of financial assets tend to move up or down over time, so these barriers can change. That’s why we need to grasp the concepts of trending and trendlines when dealing with support and resistance.
Uptrend
When the market is on an upward trend, resistance levels form as the price movement slows and starts to move back toward the trendline. If the price moves against the prevailing trend, it’s called a reaction.
Various factors can trigger reactions, like traders taking profits or short-term uncertainty about a particular asset or sector. This leads to a “plateau” effect, causing a slight drop in the stock price, creating a short-term peak.
Many traders closely monitor an asset’s price as it approaches the broader support of the trendline. Historically, this has been a point that prevents the asset’s price from significantly dropping.
Downtrend
Conversely, when the market is in a downward trend, traders watch for a series of declining peaks and connect them using a trendline. As the price approaches this trendline, most traders expect it to face selling pressure.
They may even consider entering a short position because this is an area that has historically pushed the price down. To be a valid trendline, the price must touch it at least three times.
Sometimes, with stronger trendlines, the price will touch it multiple times over longer periods. In an uptrend, the trendline is drawn below the price, while in a downtrend, it’s drawn above the price.
Strength of Support and Resistance
Regardless of how you identify support and resistance, be it through trendlines or any other method, the level’s strength increases when the price has historically struggled to move beyond it.
Many technical traders use these support and resistance levels to make strategic entry and exit decisions because these areas often have a significant impact on an asset’s direction. At these levels, most traders have confidence in the asset’s value, and trading volume usually increases, making it harder for prices to keep rising or falling.
Unlike the rational economic actors depicted in financial models, real human traders and investors are emotional and can make cognitive errors. They rely on shortcuts and heuristics. If people were always rational, support and resistance levels wouldn’t be as effective in practice!
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β€ Round Numbers in Support and Resistance
Another important aspect of support and resistance is the influence of round numbers, like $50 or $100 per share. Many people tend to think in round numbers, and this behavior carries over into the stock market. Because round numbers are easier for people to visualize, inexperienced traders often make buying or selling decisions when the price reaches a round number.
Additionally, both retail investors and large investment banks often set target prices or stop orders at round price levels instead of more precise prices like $50.06. When many orders are placed at the same round number, these levels become strong barriers to price movement.
For example, if a lot of clients from an investment bank set sell orders at a suggested target of $55, it would take a large number of purchases to absorb all these sales. This creates a level of resistance, making it challenging for prices to go beyond that point.
β€ Moving Averages Basics
Many technical traders use various technical indicators, such as moving averages, to help predict short-term momentum. For those who find it tricky to draw trendlines, moving averages can be a useful substitute. A moving average is a continuously changing line that smooths out past price data, making it easier to identify support and resistance levels.
A moving average provides support when the trend is upward and acts as resistance when the trend is downward. Traders use moving averages in different ways, like anticipating upward moves when price lines cross above a key moving average or exiting trades when the price falls below a moving average.
Regardless of how the moving average is used, it often creates automatic support and resistance levels. Most traders experiment with different time periods in their moving averages to find the one that best suits their trading timeframe.
β€ Fibonacci Retracements and Other Indicators
In the world of technical analysis, numerous indicators have been developed to identify potential barriers to future price movements.
These indicators can be plotted on price charts or positioned above or below the price itself. Initially, some of these indicators might appear complex, but with practice and experience, they can be effectively utilized.
Regardless of their apparent complexity, the fundamental use and interpretation of these indicators often resemble those of simpler methods, like calculating moving averages and drawing trendlines.
One such indicator is the Fibonacci retracement, a favorite tool among many short-term traders. It’s known for clearly pinpointing levels of potential support and resistance. The exact method of how this indicator calculates these levels is beyond the scope of this discussion.
These indicators, like the “golden ratio” used in the Fibonacci sequence, are inspired by patterns found in nature and social structures. While they may seem intricate at first, with practice, they can become valuable tools for understanding support and resistance in the world of trading.
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β€ Trading Ranges and Support/Resistance Reversals
Trading Ranges: Occasionally, price movements can become confined within certain boundaries, creating what we call trading ranges. In these ranges, support and resistance levels are relatively close, and prices bounce between these two levels for a period.
Experienced traders may sometimes engage in trading within these ranges, also known as sideways trends. One strategy they employ involves placing short trades as the price touches the upper trendline and long trades as it reverses to touch the lower trendline.
However, this strategy can be risky. It’s often wiser to wait and see which direction the price breaks out of the range before making trading decisions in that direction.
Support and Resistance Reversals: Sometimes, a previous support level can transform into a resistance level when the price attempts to move upward. Conversely, a resistance level can become a support level as the price temporarily drops.
Price charts are valuable tools for visually identifying these areas of support and resistance. Traders and investors pay attention to various aspects:
Number of Touches: The more times the price tests a support or resistance area, the more significant it becomes. When prices consistently bounce off these levels, more market participants take notice and base their trading decisions on these price points.
Preceding Price Move: Support and resistance zones tend to carry more weight when they follow steep advances or declines. For instance, a rapid, sharp uptrend might encounter stronger resistance than a slow, gradual one. This demonstrates how market psychology influences technical indicators.
Volume at Specific Price Levels: The strength of a support or resistance level often correlates with the trading activity at that price. If a lot of buying and selling occurred at a particular price level, that level is likely to be stronger.
Traders and investors remember these levels and are inclined to use them again. High-volume activity followed by a price drop suggests that a significant amount of selling may occur when the price returns to that level.
Time: Support and resistance zones seen on longer time frame charts (like weekly or monthly) typically hold more significance than those on shorter time frame charts (like one-minute or five-minute charts).
While some investors may dismiss support and resistance levels, arguing that they’re based on past price moves and don’t offer insight into the future, it’s essential to recognize that all of technical analysis relies on using past price action to anticipate future price movements.
Dismissing support and resistance levels would essentially be dismissing the entire field of technical analysis.
β€ Final thoughts
Support and resistance levels are fundamental concepts in technical analysis, forming the basis for various technical tools. At its core, support acts like a price floor, while resistance acts like a price ceiling. When prices drop, they test the support level, which can either hold and lead to an upward reversal or be broken, causing prices to fall further to the next support level.
Identifying future support levels can significantly enhance the returns of a short-term investment strategy by indicating where price declines may stop. Similarly, recognizing a resistance level can be beneficial as it signals traders to be cautious when the price approaches, anticipating a potential price reaction.
Different methods can be used to identify support and resistance, but the interpretation remains the same: Traders look for signs that the price of a security is likely to react in a specific way when it nears a recognized price level. Understanding these key concepts is essential for traders seeking to make informed decisions in the financial markets.
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