Technical Analysis: Support & Resistance Understanding
Technical analysts use a lot of concepts to determine the future price of stocks in the market. And once you have heard of trends, the next important concept in technical analysis is: Support and resistance.
Concept of Support and Resistance
This is a concept in technical analysis that says that the price of a stock tends to stop and move in the opposite direction when it hits certain pre-determined price points.
- Support level: This is a level at which the price of a stock does not fall down any further. The price is likely to bounce back and moves up in the opposite direction. This is a level where the demand from buyers is expected to be much higher than that of sellers.
- Resistance level: A resistance level is the opposite of a support level. It is a price point (ceiling) at which the stock price is not expected to rise any higher. This is a price point at which there are more sellers than buyers in the market for the particular stock.
The Resistance
As the name suggests, resistance is something which stops the price from rising further. The resistance level is a price point on the chart where traders expect maximum supply (in terms of selling) for the stock/index. The resistance level is always above the current market price.
The likelihood of the price rising to the resistance level, consolidating, absorbing all the supply, and declining is high. The resistance is one of the critical technical analysis tools which market participants look at in a rising market. The resistance often acts as a trigger to sell.
The Support
Having learnt about resistance, understanding the support level should be quite simple and intuitive. As the name suggests, support is something that prevents the price from falling further. The support level is a price point on the chart where the trader expects maximum demand (in terms of buying) coming into the stock/index. Whenever the price falls to the support line, it is likely to bounce back. The support level is always below the current market price.
There is a maximum likelihood that the price could fall until the support, consolidate, absorb all the demand, and then start moving upwards. The support is one of the critical technical level market participants look for in a falling market. The support often acts as a trigger to buy.
Psychology of support and resistance
Let’s use a few examples of market participants to explain the psychology behind support and resistance.
First let’s assume there are buyers who’ve been buying a stock close to a support area. Let’s say that support level is $50. They buy some stock at $50 and now it moves up and away from that level to $55. The buyers are happy and want to buy more stock at $50, but not $55. They decide if the price moves back down to $50, they will buy more. They’re creating demand at the $50 level.
Let’s take another group of investors. These are the people that were uncommitted. They were thinking about buying the stock at $50 but never “pulled the trigger.” Now the stock is at $55 and they regret not buying it. They decide that if it gets to $50 again, they will not make the same mistake and they will buy the stock this time. This creates potential demand.
The third group bought the stock below $50; let’s say they bought it at $40. When the stock got to $50, they sold their stock, only to watch it go to $55. Now they want to re-establish their long positions and want to buy it back at the same price they sold it, $50. They’ve changed their sentiment from sellers to buyers. They regret selling it and want to right that wrong. This creates more demand.
Now let’s change things up to help understand resistance. Take all the above participants and say they all own the stock at $50. Imagine yourself as one of the owners at $50. The stock goes to $55 and you don’t sell. Now the stock goes back to $50, where you own it. What are you feeling? Regret for not selling it at $55? Now it goes back to $55 and you sell as much as you can this time. So do the other owners of the stock. The stock can’t get past $55 and retreats. There are at least 3 groups of stock owners that are trying to sell their supply at $55. This creates a resistance level at $55.
These are just a few examples of many possible scenarios. If you’ve traded before, you’ve probably been through all of these scenarios and experienced the emotions and psychology behind them. You’re not alone. There are countless market participants going through the same emotions and thought processes as you, and this is what helps determine some of the market psychology behind support and resistance, and technical analysis in general.
How to Use Support and Resistance to Make Better Trading Decisions
Simply put, an area of support is where the price of an asset tends to stop falling, and an area of resistance is where the price tends to stop rising. But traders really need more information about support and resistance beyond those simple definitions before they attempt to make trading decisions based on those areas in a chart.
To use support and resistance effectively, you first need to understand how asset prices typically move, so you can then interpret support and resistance from that framework. You also need to be aware that there are different types of support and resistance, such as minor and major/strong. Minor levels are expected to be broken, while strong levels are more likely to hold and cause the price to move in the other direction.
- 1.Using Trendlines
Support and resistance are highlighted with horizontal or angled lines, called "trendlines." If the price stalls and reverses in the same price area on two different occasions in succession, then a horizontal line is drawn to show that the market is struggling to move past that area.
In an uptrend, the price makes higher highs and higher lows. In a downtrend, the price makes lower lows and lower highs. Connect the highs and lows during a trend. Then extend that line out to the right to see where the price may potentially find support or resistance in the future.
These simple lines highlight trends, ranges, and other chart patterns. They provide traders with a view of how the market is currently moving and what it could do in the future.
- 2.Minor and Major Resistance and Support levels
Suppose in the uptrend the price will be making higher high suddenly there will be a little pullback and then it will continue to make higher highs.
This pullback can be considered as the minor support area as the price bounced back from that area.
These areas of minor support and resistance provide opportunities for increasing your holding.
Major levels are those areas that create trend reversals.
When the prices are making higher highs and are in an uptrend, then reversed into a downtrend, the area at which the reversal took place can be considered as a major resistance level.
- 3.Adapting Trading Decisions to New Support and Resistance Levels
Support and resistance are dynamic, and so your trading decisions based on them must also be dynamic. In an uptrend, the last low and last high are important. If the price makes a lower low, it indicates a potential trend change, but if it makes a new high, that helps confirm the uptrend. Focus your attention on the support and resistance levels that matter right now. Trends often encounter trouble at strong areas. They may eventually break through, but it often takes time and multiple attempts.
Mark major support and resistance levels on your chart, as they could become relevant again if the price approaches those areas. Delete them once they are no longer relevant for example, if the price breaks through a strong support or resistance area and continues to move well beyond it.
Also mark the current and relevant minor support and resistance levels on your chart. These will help you analyze the current trends, ranges, and chart patterns. These minor levels lose their relevance quite quickly as new minor support and resistance areas form. Keep drawing the new support and resistance areas, and delete support and resistance lines that are no longer relevant because the price has broken through them.
If you're day trading, focus on today, and don't get too bogged down with figuring out where support and resistance were on prior days. Trying to look at too much information can easily result in information overload. Pay attention to what is happening now, and mark today's support and resistance levels as they form.
Trading off support and resistance takes lots of practice. Work on isolating trends, ranges, chart patterns, support, and resistance in a demo account, and then practice taking trades with targets and stop-losses. Only once you are profitable for several months with your support-and-resistance trading method should you consider trading with real money.
- 4.Trading decisions based on new Support and Resistance levels
When the prices are in an uptrend, then the last low and the last high prices are very important.
If the prices start making a lower low, then it indicates trend reversal may take place.
But if the prices continue to make higher highs then the uptrend is confirmed.
One should mark the relevant and current major support and resistance levels as they may become important when the prices approach that level.
Also one should mark the relevant and current minor support and resistance levels which will help you in analysing the current trends, chart patterns, and ranges.
You should keep drawing new support and resistance level and delete the old support and resistance levels which are no longer important as the prices have already broken through them.
- 5.False Breakouts
Asset prices will often move slightly further than we expect them to. This doesn't happen all the time, but when it does it is called a "false breakout." If our analysis shows that there is support at $10, it is quite possible that the price could drop through $10, to $9.97 or $9.95 for example, and then start to rally again. Support and resistance are areas, not an exact price. Expect some variability in how the price acts around support and resistance. It is unlikely to stop at the exact same price as before.
False breakouts are excellent trading opportunities. One strategy is to actually wait for a false breakout, and enter the market only after it occurs. For example, if the trend is up, and the price is pulling back to support, let the price break below support and then buy when it starts to rally back above support.
Similarly, if the trend is down, and the price is pulling back to resistance, let the price break above resistance, and then short-sell when the price starts to drop below resistance.
The downside to this approach is that a false breakout won't always occur. Waiting for one means that good trading opportunities could be missed. Therefore, it is typically best to take trading opportunities as they come. If you happen to catch the odd false breakout trade, that's a bonus.
Because false breakouts occur on occasion, the stop-loss should be placed a bit of distance away from support or resistance, so that the false breakout isn't likely to hit your stop-loss position before moving in your anticipated direction.
Measuring the Significance of Zones
Remember how we used the terms "floor" for support and "ceiling" for resistance? Continuing the house analogy, the security can be viewed as a rubber ball that bounces in a room will hit the floor (support) and then rebound off the ceiling (resistance). A ball that continues to bounce between the floor and the ceiling is similar to a trading instrument that is experiencing price consolidation between support and resistance zones.
Now imagine that the ball, in mid-flight, changes to a bowling ball. This extra force, if applied on the way up, will push the ball through the resistance level; on the way down, it will push the ball through the support level. Either way, extra force, or enthusiasm from either the bulls or bears, is needed to break through the support or resistance.
A previous support level will sometimes become a resistance level when the price attempts to move back up, and conversely, a resistance level will become 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 regarding the significance of these price levels.