At first the explanation and idea behind identifying these levels seems easy, but as you'll find out, support and resistance can come in various forms and it is much more difficult to master than it first appears.
The Basics
Most experienced traders will be able to tell many stories about how certain price levels tend to prevent traders from pushing the price of an underlying asset in a certain direction. For example, assume that Jim was holding a position in Amazon.com (AMZN) stock between March and November 2006 and that he was expecting the value of the shares to increase. Let's imagine that Jim notices that the price fails to get above $39 several times over the past several months, even though it has gotten very close to moving above it. In this case, traders would call the price level near $39 a level of resistance. As you can see from the chart below, resistance levels are also regarded as a ceiling because these price levels prevent the market from moving prices upward.
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| Figure 1 |
On
the other side of the coin, we have price levels that are known as
support. This terminology refers to prices on a chart that tend to act
as a floor by preventing the price of an asset from being pushed
downward. As you can see from the chart below, the ability to identify a
level of support can also coincide with a good buying opportunity
because this is generally the area where market participants see good
value and start to push prices higher again.
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| Figure 2 |
In
the examples above, you've seen a constant level prevent an asset's
price from moving higher or lower. This static barrier is one of the
most popular forms of support/resistance, but the price of financial
assets generally trends upward or downward so it is not uncommon to see
these price barriers change over time. This is why understanding the concepts of trending and trendlines
is important when learning about support and resistance. When the
market is trending to the upside, resistance levels are formed as the
price action slows and starts to pull back toward the trendline. This
occurs as a result of profit taking
or near-term uncertainty for a particular issue or sector. The
resulting price action undergoes a "plateau" effect or slight drop-off
in stock price, creating a short-term top.
Many
traders will pay close attention to the price of a security as it falls
toward the broader support of the trendline because historically, this
has been an area that has prevented the price of the asset from moving
substantially lower. For example, as you can see from the Newmont Mining
Corp (NEM) chart below, a trendline can provide support for an asset
for several years. In this case, notice how the trendline propped up the
price of Newmont's shares for an extended period of time.
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| Figure 3 |
On the other hand, when the market is trending to the downside, traders will watch for a series of declining peaks and will attempt to connect these peaks together with a trendline. When the price approaches the trendline, most traders will watch for the asset to encounter selling pressure and may consider entering a short position because this is an area that has pushed the price downward in the past.
The support/resistance of an identified level, whether discovered with a trendline or through any other method, is deemed to be stronger the more times that the price has historically been unable to move beyond it. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit prices because these areas often represent the prices that are the most influential to an asset's direction. Most traders are confident at these levels in the underlying value of the asset so the volume generally increases more than usual, making it much more difficult for traders to continue driving the price higher or lower.
Another common
characteristic of support/resistance is that an asset's price may have a
difficult time moving beyond a round price level such as $50. Most
inexperienced traders tend to buy/sell assets when the price is at a
whole number because they are more likely to feel that a stock is fairly
valued at such levels. Most target prices/stop orders
set by either retail investors or large investment banks 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 tend to act as
strong price barriers. If all the clients of an investment bank put in
sell orders at a suggested target of, for example, $55, it would take an
extreme number of purchases to absorb these sales and, therefore, a
level of resistance would be created.
Moving Averages
Most technical traders incorporate the power of various technical indicators, such as moving averages,
to aid in predicting future short-term momentum, but these traders
never fully realize the ability these tools have for identifying levels
of support and resistance. As you can see from the chart below, a moving
average is a constantly changing line that smooths out past price data
while also allowing the trader to identify support and resistance.
Notice how the price of the asset finds support at the moving average
when the trend is up, and how it acts as resistance when the trend is
down. Most traders will experiment with different time periods in their
moving averages so that they can find the one that works best for this
specific task.
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| Figure 4 |
In
technical analysis, many indicators have been developed to identify
barriers to future price action. These indicators seem complicated at
first and it often takes practice and experience to use them
effectively. Regardless of an indicator's complexity, however, the
interpretation of the identified barrier should be consistent to those
achieved through simpler methods.
For example, the Fibonacci retracement tool is a favorite among many short-term traders because it clearly identifies levels of potential support/resistance.
The reasoning behind how this indicator calculates the various levels
of support and resistance is beyond the scope of this article, but
notice in Figure 5 how the identified levels (dotted lines) are barriers
to the short-term direction of the price.
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| Figure 5 |
Determining
future levels of support can drastically improve the returns of a
short-term investing strategy because it gives traders an accurate
picture of what price levels should prop up the price of a given
security in the event of a correction. Conversely, foreseeing a level of
resistance can be advantageous because this is a price level that could
potentially harm a long position because it signifies an area where
investors have a high willingness to sell the security. As mentioned
above, there are several different methods to choose when looking to
identify support/resistance, but regardless of the method, the
interpretation remains the same - it prevents the price of an underlying from moving in a certain direction.
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