Support and Resistance Basics

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Support and Resistance Basics

Technical analysis is built on two fundamental concepts: support and resistance. Understanding what these concepts signify and how to use them is critical for effectively reading price charts.

Prices fluctuate according to supply and demand. When demand exceeds supply, prices increase. Prices decrease when supply exceeds demand. Prices will sometimes go sideways when supply and demand are in balance.

Like many concepts in technical analysis, the explanation and rationale behind technical concepts are relatively easy, but mastery in their application often takes years of practice.

Key Takeaways

  • Support and resistance levels are used by technical analysts to indicate price areas on a chart where the odds favor a halt or reversal of a current trend.
  • When a downturn is projected to halt owing to a concentration of demand, support arises.
  • When an upswing is predicted to stall briefly owing to a concentration of supply, resistance arises.
  • Market psychology is important because traders and investors recall the past and respond to changing circumstances in order to forecast future market movement.
  • Trendlines and moving averages may be used to identify support and resistance regions on charts.

Trading With Support And Resistance

What Is Support?

In a downtrend, prices fall because there is an excess of supply over demand. The lower prices go, the more attractive prices become to those waiting on the sidelines to buy the shares. At some level, demand that would have been slowly increasing will rise to the level where it matches supply. At this point, prices will stop falling. This is support.

Support can be a price level on the chart or a price zone. In any event, support is an area on a price chart that shows buyers’ willingness to buy. It is at this level that demand will usually overwhelm supply, causing the price decline to halt and reverse.

What Is Resistance?

Resistance is the opposite of support. Prices move up because there is more demand than supply. As prices move higher, there will come a point when selling will overwhelm the desire to buy. This happens for a variety of reasons. It could be that traders have determined that prices are too high or have met their target. It could be the reluctance of buyers to initiate new positions at such rich valuations. It could be for any other number of reasons. But a technician will clearly see on a price chart a level at which supply begins to overwhelm demand. This is resistance. Like support, it can be a level or a zone.

Once an area or “zone” of support or resistance has been identified, those price levels can serve as potential entry or exit points because, as price reaches a point of previous support or resistance, it will do one of two things: bounce back away from the support or resistance level, or violate the price level and continue in its prior direction—until it hits the next support or resistance level.

The timing of some trades is based on the belief that support and resistance zones will not be broken. Whether the price is halted by or breaks through the support or resistance level, traders can “bet” on the direction of price and can quickly determine if they are correct. If the price moves in the wrong direction (breaks through prior support or resistance levels), the position can be closed at a small loss. If the price moves in the right direction (respects prior support or resistance levels), however, the move may be substantial.

The Basics

Support and resistance can be found in all charting time periods; daily, weekly, monthly. Traders also find support and resistance in smaller time frames like one-minute and five-minute charts. But the longer the time period, the more significant the support or resistance. To identify support or resistance, you have to look back at the chart to find a significant pause in a price decline or rise. Then look forward to see whether a price halts and/or reverses as it approaches that level. As has been noted above, many experienced traders will pay attention to past support or resistance levels and place traders in anticipation of a future similar reaction at these levels.

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Technical analysis is not an exact science, and sometimes price will dip below support levels or reverse before it gets to the prior support level. The same is true for resistance: Price may reverse before it gets to the prior resistance level or break above it. In each case, flexibility is required in interpreting these chart patterns. This is why support and resistance levels are sometimes referred to as zones.

These price levels are not magical in any way. Simply put, many market participants are acting on the same information and making similar trades.

Most experienced traders can tell you tales about how an asset’s price tends to stall when it reaches a specific level. Assume Jim had a stock stake from March to November, with the expectation that the value of the shares would rise.

Assume Jim notes that the price fails to rise beyond $39 multiple times over the course of several months, despite being quite near to doing so. Traders would classify the price level at $39 as a level of resistance in this scenario. As seen in the chart below, resistance levels are also considered as a ceiling since they signify regions where a rally runs out of steam.

Image by Sabrina Jiang © Investopedia2020

On the other hand, support levels are low. The price level on a chart at which equilibrium is attained is referred to be support. This indicates that demand has risen to equal supply. As a result, the asset’s price decrease comes to a stop, and the price has achieved a price floor. The horizontal line below the price symbolizes the price floor, as seen in the chart below. The blue arrows under the vertical line show that price has already reached this level four times. This is the point at which demand kicks in, barring further decreases. This is assistance.

Image by Sabrina Jiang © Investopedia2020

Trendlines

The preceding examples demonstrate how a constant level prohibits an asset’s price from going higher or lower. This is one of the most prevalent types of support/resistance, however since the price of financial assets normally moves upward or downward, it is not unusual for these price barriers to fluctuate over time. This is why trends and trendlines are crucial concepts to understand while studying about support and resistance.

When the market is heading upward, resistance levels arise when price activity slows and begins to return to the trendline. A response occurs when price moves against the current trend. Reactions may arise for a number of causes, including as profit taking or near-term anxiety about a certain topic or industry. The price action that results has a “plateau” effect, or a minor decline in stock price, culminating in a short-term top.

Many traders will pay particular attention to the price of a security as it falls near the trendline’s wider support since, historically, this has been a region that has kept the asset’s price from falling far lower. A trendline, for example, might offer support for an asset for many years, as seen in the Newmont Corp. (NEM) chart below. Take note of how the trendline supported the price of Newmont’s shares for a lengthy period of time in this situation.

Image by Sabrina Jiang © Investopedia2020

When the market is heading downward, traders will look for a succession of dropping peaks and will try to link these peaks with a trendline. When the price approaches the trendline, most traders will look for selling pressure and may consider opening a short position since this is an area that has historically driven the price lower. Price must contact the trendlines at least three times for them to be legitimate. Price may contact the trendline numerous times over longer time periods with stronger trendlines. In addition, the trendline is drawn below the price in an uptrend and above the price in a downtrend.

The support/resistance of an identified level is judged to be greater the more times the price has historically been unable to advance beyond it, whether detected using a trendline or by any other means. Many technical traders will utilize their discovered support and resistance levels to choose strategic entry/exit locations since these regions often indicate the prices that are most significant to the direction of an asset. At these levels, most traders are confidence in the asset’s fundamental worth, therefore volume typically grows more than normal, making it much more difficult for traders to continue moving the price higher or down.

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Real human traders and investors, unlike the logical economic agents described by financial models, are emotional, make cognitive mistakes, and rely on heuristics or shortcuts. Support and resistance levels would not operate in reality if individuals were sensible!

Round Numbers

Another feature of support/resistance is that an asset’s price may struggle to go beyond a round amount, such as $50 or $100 per share. Many individuals think in terms of round numbers, which extends to the stock market. Because round figures are simpler to visualize, many beginner traders choose to purchase or sell assets when the price is at a round number.

Furthermore, many target prices or stop orders made by private investors or major investment banks are set at round price levels rather than values like $50.06. Because there are so many orders made at the same level, these round numbers operate as powerful pricing barriers. For example, if all of an investment bank’s customers placed sell orders at a recommended target of $55, it would require an unusually large number of purchases to absorb these sales, creating a degree of resistance.

Moving Averages

Most technical traders use the strength of technical indicators such as moving averages to forecast future short-term momentum. In fact, those who find it difficult to create trendlines may often substitute moving averages for them. A moving average, as seen in the chart below, is a continually shifting line that smooths out prior price data, making it simpler to identify support and resistance. When the trend is up, the price of the asset in the chart below finds support at the moving average, and when the trend is down, it works as resistance.

Image by Sabrina Jiang © Investopedia2020

Moving averages may be used by traders in a number of ways, including anticipating advances to the upside when price lines cross above a significant moving average or exiting bets when the price falls below a moving average. Whatever method is utilized, the moving average often generates “automatic” support and resistance levels. Most traders will experiment with various moving average time periods to discover the one that works best for their trading time frame.

Other Indicators

Many indicators have been established and are continually being produced in technical analysis to indicate impediments to future price movement. Some indicators appear on price charts, while others appear above or below the price. These signs might seem confusing at first, and learning to utilize them successfully requires practice and expertise. However, regardless matter how complicated an indicator seems, its application and interpretation are often the same as those of other indicators constructed using simpler approaches such as computing moving averages and drawing trendlines.

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The “golden ratio” seen in the Fibonacci sequence is also found in nature and societal organization.

The Fibonacci retracement, for example, is a popular technique among many short-term traders since it clearly highlights levels of probable support/resistance. The explanation behind how this indicator calculates the different levels of support and resistance is outside the scope of this article, but observe how the indicated levels (dotted lines) in the chart below act as barriers to the price’s short-term direction.

Image by Sabrina Jiang © Investopedia2020

Trading Ranges

Trading ranges may occur on occasion. These are situations where support and resistance levels are close together and price swings between them for a period of time. Experiential traders may sometimes trade inside these trading ranges, often known as sideways trends. They employ one method in which they make short bets when the price meets the higher trendline and long trades when the price reverses to touch the lower trendline. This method is incredibly risky, and it is much preferable to wait for price to break out of the range and then make your bets in that direction.

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Support and Resistance Reversals

When the price attempts to move back up, a previous support level may become a resistance level, and vice versa, a resistance level may become a support level as the price temporarily falls back.

Price charts enable traders and investors to visually identify regions of support and resistance, as well as provide information about the importance of certain price levels. They especially examine:

Number of Touches

The more often the price tests a level of support or resistance, the more meaningful the level becomes. When prices continue to bounce off a support or resistance level, more buyers and sellers take note and make trading choices based on these levels.

Preceding Price Move

When support and resistance zones are preceded by sharp rises or drops, they are more likely to be substantial. A quick, steep gain or uptrend, for example, will be greeted with greater rivalry and excitement and may be stopped by a higher level of resistance than a calm, steady advance. Slow progress may not get as much notice. This is an excellent illustration of how market psychology influences technical indicators.

Volume at Certain Price Levels

The greater the volume of buying and selling at a certain price level, the stronger the support or resistance level is likely to be. This is due to the fact that traders and investors remember these price levels and are likely to employ them again. When there is a lot of activity on high volume and the price decreases, there will most likely be a lot of selling when the price recovers to that level, since individuals are considerably more comfortable closing out a trade at the breakeven point than at a loss.

Time

Longer time frame charts, such as weekly or monthly charts, generally have more substantial support and resistance zones than shorter time frame charts, such as one-minute or five-minute charts.

Some investors disregard support and resistance levels altogether, claiming that they are based on previous price movements and provide no genuine insight into what may happen in the future. However, since all technical analysis is predicated on utilizing previous market action to forecast future price movements, this is a case for ignoring technical analysis outright.

The Bottom Line

Technical analysts rely heavily on support and resistance levels, which serve as the foundation for a broad range of technical analysis tools. The fundamentals of support and resistance are a support level, which can be thought of as the floor under the price, and a resistance level, which can be thought of as the roof above the price. Prices fall and test the support level, which will either hold and cause the price to reversal to the upside, or it will be violated, causing the price to fall through the support and likely continue down to the next support level.

Determining future levels of support may significantly increase the profits of a short-term investment strategy since it tells traders where price drops are expected to stop. Foreseeing a level of resistance, on the other hand, might be useful since it alerts traders to be watchful as price approaches this region for a possible price response. As previously said, there are numerous approaches to pick from when attempting to determine support/resistance, but the meaning stays the same: The trader is seeking for signs that the price of an asset will likely respond in a specific way when it approaches and reaches a certain price level.

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