Support and Resistance Basics
Support and Resistance Basics
Support and resistance are two fundamental concepts in technical analysis. It is essential to understand what these terms mean and their practical application in order to read price charts correctly.
Prices move due to supply and demand. When demand exceeds supply, prices rise. When supply exceeds demand, prices fall. Sometimes prices move sideways because both supply and demand are in equilibrium.
Like many concepts in technical analysis, the explanations and reasoning behind technical concepts are relatively easy, but mastering their application often takes years of practice.
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Key Takeaways
- Technical analysts use support and resistance levels to identify price points on a chart where probabilities favor a stop or reversal of a prevailing trend.
- Support occurs when the downtrend is expected to stop due to the concentration of demand.
- Resistance occurs when an uptrend is expected to stop temporarily due to a concentration of supply.
- Market psychology plays a major role as traders and investors remember the past and react to changing conditions to anticipate future market movement.
- Support and resistance areas can be identified on charts using trendlines and moving averages.
What is Support?
In a downtrend, prices fall because supply exceeds demand. The lower prices go, the more attractive those prices become to those waiting to buy shares. At some point, the demand which has been rising slowly will rise to a level where it matches the supply. At this point the prices will stop falling. This is support.
Support can be a price level on the chart or a price area. In any event, support is an area on the price chart that shows buyers' willingness to buy. It is at this level that demand usually overcomes supply, causing the price to stop falling and reverse.
What is Resistance?
Resistance is the opposite of support. Prices rise because there is more demand than supply. As prices rise, there will come a time when selling will outweigh the desire to buy. This happens due to many reasons. It could be that traders have determined that prices are overpriced or have met their targets. There could be reluctance of buyers to initiate new positions at such rich valuations. This could be due to many other reasons as well. But a technician will clearly see a level on the price chart at which supply begins to exceed demand. This is resistance. Like support, it can be a level or area.
Once an area or "zone" of support or resistance is identified, those price levels can serve as potential entry or exit points, as the price reaches the point of previous support or resistance, it can do two things: Will do one of: bounce back from the support or resistance level, or breach the price level and continue in its former direction - until it reaches the next support or resistance level.
The timing of some trades is based on the belief that support and resistance areas will not be broken. Whether the price stalls or breaks a support or resistance level, traders can "bet" on the direction of the price and quickly determine whether they are correct. If the price moves in the wrong direction (breaks through the former support or resistance levels), the position can be closed at a small loss. If price moves in the right direction (respecting prior support or resistance levels), however, the move could be substantial.
The Basics
Support and resistance can be found on all charting timeframes; daily Weekly Monthly. Traders also find support and resistance in smaller time frames such as the one-minute and five-minute charts. But the longer the time period, the more important the support or resistance. To identify support or resistance, you need to look back at the chart to find a significant pause in the price's decline or rise. Then watch to see if the price pauses and/or reverses as it reaches that level. As mentioned above, many experienced traders will look at previous support or resistance levels and place traders at these levels in anticipation of a similar reaction in the future.
Technical analysis is not an exact science, and sometimes price will break below support levels or reverse before reaching a former support level. The same is true for resistance: price may reverse before reaching or breaking above the former resistance level. In each case, flexibility is required in interpreting these chart patterns. This is why support and resistance levels are sometimes called zones.
There is nothing magical about these price levels. It's just that many market participants are acting on the same information and placing trades at similar levels.
Most experienced traders can share stories about how an asset stops when its price reaches a certain level. For example, let's say Jim was holding a position in the stock from March to November and he was expecting the shares to increase in value.
Let's imagine that Jim notices that the price fails to move above $39 several times over several months, even though it has come very close to moving above that level. In this case, traders would refer to the price level near $39 as a level of resistance. As you can see from the chart below, resistance levels are also considered as ceilings as these price levels represent areas where the rally runs out of gas.
Support levels are on the other side of the coin. Support refers to the price level on a chart where equilibrium is reached. This means that demand has increased in line with supply. This arrests the fall in the price of the asset; Hence, the price has hit a price low. As you can see from the chart below, the horizontal line below the price represents the price floor. You can see by the blue arrows below the vertical line that the price has touched this level four times in the past. This is the level where demand kicks in, and stops the decline. This is support.
Trendlines
The examples above show that a stablecoin prevents the price of an asset from going up or down. This static barrier is one of the most popular forms of support/resistance, but the price of financial assets typically moves in an upward or downward direction, so it is not uncommon for these price barriers to change over time. This is why the concepts of trending and trendlines are important when learning about support and resistance.
When the market is trending up, resistance levels are formed as the price slows down and begins to move back towards the trendline. When the price moves against the current trend, it is called a reaction. Reactions can occur for a variety of reasons, including profit-taking or near-term uncertainty for a particular issue or sector. The resulting price action undergoes a "plateau" effect, or a slight decline in the stock's price, forming a short-term top.
Many traders will watch the security's price as it falls toward the broad support trendline because, historically, this has been an area that has prevented the asset's price from moving significantly lower. For example, as you can see from the Newmont Corp (NEM) chart below, a trendline can provide support for an asset for several years. In this case, notice how the trendline drove Newmont's share price up for an extended period of time.
On the other hand, when the market is trending down, traders will look for a series of declines and try to connect these peaks with a trendline. When the price reaches the trendline, most traders will keep an eye on the asset to counter the selling pressure and may consider entering a short position as this is an area that has pushed the price down in the past . To be a valid trendline, the price needs to touch the trendline at least three times. Sometimes with a strong trendline, the price will touch the trendline several times over a long period of time. Furthermore, in an uptrend, the trendline is drawn below the price, while in a downtrend, the trendline is drawn above the price.
An identified support/resistance level, whether discovered along a trendline or through some other method, is more often considered strong than the price has historically been unable to move beyond. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit points as these areas often represent the prices that are most influential to the direction of an asset. Most traders are confident in the underlying value of the asset at these levels, so volume typically increases more than usual, making it more difficult for traders to continue pushing the price higher or lower.
Important Note
Unlike the rational economic actors portrayed by financial models, real human traders and investors are emotional, make cognitive errors, and fall back on heuristics or shortcuts. If people were rational, support and resistance levels would not work in practice!
Round Number
Another common feature of support/resistance is that it may be difficult for an asset's price to move beyond a round number such as $50 or $100 per share. Many people think of it as a round number, and it moves in the stock market. Because people have an easier time visualizing round numbers, many inexperienced traders tend to buy or sell assets when the price is round numbers.
In addition, many target prices or stop orders are placed at round price levels rather than at prices such as $50.06. Because so many orders are placed at the same level, these round numbers act as strong price barriers. For example, if all of an investment bank's clients placed sell orders at the suggested target of $55, an excessive number of buys would have to be made to absorb these sells and, therefore, a level of resistance would have been created.
Moving Average
Most technical traders incorporate the power of various technical indicators, such as moving averages, to help forecast future short-term momentum. In fact, people who find trendlines difficult to draw will often substitute them for moving averages. As you can see from the chart below, a moving average is a continuously moving line that smooths past price data, allowing for easy identification of support and resistance. Notice how in the chart below the moving average acts as support when the asset's price is above the trend, and as resistance when it is below the trend.
Traders can use moving averages in a variety of ways, such as to speculate on moving averages when price lines move above a key moving average, or to exit trades when price moves below a moving average. Regardless of how the moving average is used, it often creates "automatic" support and resistance levels. Most traders will experiment with different time periods in their moving averages to find what works best for their trading time frame.
Other Indicators
In technical analysis, many indicators have been developed and are still being developed to identify barriers to future price action. Some indicators are plotted on a price chart, while others are plotted above or below price. These indicators can often seem complicated at first, and it takes practice and experience to learn how to use them effectively. But regardless of how complex an indicator appears, its use and interpretation are often no different from other indicators created using simpler methods, such as calculating moving averages and drawing trendlines.
1.62The "golden ratio", used in the Fibonacci sequence, was also seen repeatedly in nature and in social structure.
For example, the Fibonacci retracement is a favorite tool among many short-term traders because it clearly identifies potential support/resistance levels. The logic behind how this indicator calculates the various levels of support and resistance is beyond the scope of this article, but note in the chart below how the identified levels (dotted lines) are barriers to the price's short-term direction .
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Trading Range
Trading ranges can occur at times. These are areas where the support and resistance levels are relatively close and price bounces between the two levels for a period of time. Experienced traders sometimes trade within these trading ranges, also known as sideways trends. One strategy they use is to place short trades as the price touches the upper trendline and long trades as the price touches the lower trendline as the price reverses. This strategy is extremely risky, and it is better to wait to see in which direction the price will break out of the range and then place your trades in that direction.
Support and Resistance Reversal
A previous support level sometimes becomes a resistance level when the price attempts to move back up, and conversely, a resistance level becomes a support level as the price temporarily falls back.
Price charts allow traders and investors to visually identify areas of support and resistance, and they give clues about the importance of these price levels. More specifically, they look at:
Number of Touches
The more often the price tests a support or resistance area, the more important that level becomes. When prices bounce off a support or resistance level, more buyers and sellers make trading decisions at these levels.
Previous Price Move
Support and resistance areas are likely to be more important when they are preceded by sharp advances or declines. For example, a rapid, rapid advance or uptrend will be met with more competition and enthusiasm and may be stopped by a more significant resistance level than a slow, steady advance. A slow progress may not attract as much attention. This is a good example of how market psychology drives technical indicators.
Can't attract attention. This is a good example of how market psychology drives technical indicators.
Volume at Certain Price Levels
The more buying and selling that has taken place at a particular price level, the stronger the support or resistance level is likely to be. This is because traders and investors remember these price levels and are apt to use them again. When there is strong activity on high volume and the price falls, there is a possibility of a lot of selling when the price returns to that level, as people are more comfortable closing the trade at the break even point than at a loss.
Time
Support and resistance areas seen in longer time frame charts such as weekly or monthly charts are often more important than those seen in shorter time frame charts such as one minute or five minute charts.
Important Note
Some investors dismiss support and resistance levels altogether because they say that the levels are based on past price movements, which provide no real information about what will happen in the future. But all technical analysis is based on using past price action to forecast future price movements; Therefore, this is an argument for rejecting technical analysis altogether.
Last Line
Support and resistance levels are key concepts used by technical analysts and form the basis of a variety of technical analysis tools. The basics of support and resistance consist of a support level, which can be thought of as the floor below the price, and a resistance level, which can be thought of as the ceiling above the price. Prices drop and test the support level, which will either hold, and price will reverse, or be violated, and price will break through support and possibly continue lower until the next support level.Determining future levels of support can greatly improve the returns of a short-term investment strategy because it gives traders an indication of where price declines may stop. Conversely, forecasting a level of resistance can be beneficial as it will alert traders to be vigilant as price approaches this area for a potential reaction in price. As mentioned above, there are a number of different methods to choose from when identifying support/resistance, but regardless of the method, the interpretation remains the same: the trader is looking for an indication that the security's price is definitely on the way up. The way it reaches and touches a recognized price level.