Technical analysis is a complex subject, and as such, there are many layers to it. It analyzes statistical trends that draw from trading activity, such as price movement and volume. The concepts that tie into it are plentiful, though some garner more attention than others. Two of these concepts are support and resistance. Both of them are inarguably the most highly examined and discussed aspects behind proper technical analysis.
As part of chart pattern analytics, traders use support and resistance when referring to price levels on charts. Specifically, price levels that have a tendency to function as barriers, which prevent an asset’s price from being forced into a certain direction.
In the beginning, the explanation and idea behind identifying these levels appear to be very simple. This is, however, not the case. You will eventually discover that support and resistance can come in a variety of different forms. Moreover, the concept is actually more difficult to fully grasp than it initially appears.
What are Support Levels?
‘Support’ is indicative of the price level that an asset does not drop below for a period of time. The creation of an asset’s support level is thanks to buyers entering the market whenever the asset’s price declines. In technical analysis, one can chart the support level by way of drawing a line along the lowest lows for a certain time period.
The support line can either be flat or on an angle going up or down with the overall price trend. There are other technical indicators and charting techniques that can help identify more state-of-the-art versions of support.
Generally speaking, in terms of finance, the support level is the level where buyers often purchase or enter into a stock. It concerns the price of a stock share that a company will very rarely go below. Whenever the price of the stock drops towards its support level, the support level holds and is confirmed. Alternatively, the stock proceeds to fall and the previous support level has to modify for the incorporation of new lows. The creation of support levels in stocks can derive from limit orders. Sometimes, they can just be the market action of traders and investors.
When you look at support as a whole, it is more of a market concept than a true technical indicator. There are an array of popular indicators that integrate these concepts, such as price by volume charts and moving averages. Those ones are comparatively more prone to action than the simpler visualizations. Traders will often want to see the support band instead of a single line that connects the lowest lows. This is because there’s always a possibility of support moving up and the order for a long position going without execution.
What are Resistance Levels?
‘Resistance’ refers to the price point where the rise in the asset price comes to a halt. The reason for this halt is the emergence of a growing number of sellers who want to sell at that price. Resistance levels can often have a short lifespan if new information comes along to change the market’s attitude toward the asset. There are times, however, when they can be enduring.
When it comes to technical analysis, one can chart the resistance level by drawing a line along with the highest highs for a certain time period. This line can be flat or on an angle, though this largely depends on the price action. There are other methods of resistance identification by incorporating bands, trendlines, and moving averages.
Overall, resistance is much more of a market concept than a true technical indicator. Again, there are comparatively better technical analysis tools that integrate the concept of resistance while also being more dynamic and informative. That is to say, it is better than drawing a resistance line across the more recent highs. These include trendlines, charts that determine the price by volume, and many moving averages that one can tweak by time periods. This will effectively provide a solid spectrum for resistance levels.
Both support and resistance are integral concepts; they are interdependent and correlate with each other. Resistance facilitates the establishment of the current price ceiling for the stock, commodity, or currency. What’s more, it provides the support that forms the floor. Whenever the price action breaches either support or resistance, it then transforms into a trading opportunity.
Psychology of the market
Market psychology references the prominent belief that financial market participants share at any point in time. Investor sentiment is what frequently drives the performance of the market in directions that are actively conflicting with fundamentals. For instance, if investors were to suddenly lose confidence and opt to pull back, then markets could potentially fall.
A good portion of trading and investing approaches do not have a heavy reliance on fundamental analysis for evaluating opportunities. Technical analysts, for example, use trends, patterns, and a variety of other indicators to assess the market’s current psychological state. It does this in order to make a prediction on whether the market is heading in an upward or downward direction.
Market psychology plays a major role when it comes to support and resistance. This is due largely in part to traders and investors remembering the past. Moreover, the fact that they react to the constantly changing conditions to further anticipate any future movements in the market.
The basics of support and resistance levels
Most traders with experience have a lot of stories to tell when it comes to certain price levels. Specifically, how they are prone to keeping traders from forcing the price of an underlying asset in a certain direction. To better explain this, let’s set up a hypothetical situation.
Imagine that a person was holding a position in stock between the months of March and November. Moreover, they were expecting the value of the shares to increase at some point. Now, let’s assume that the person takes note of the price continuously failing to get above $39 over several months. This is despite the fact that it has gotten incredibly close to exceeding that level.
In this particular case, traders would call the price level near $39 a level of resistance accordingly. Resistance levels tend to be regarded as a ceiling. This is largely due to these price levels preventing the market from moving prices upward.
On the flip side, we have price levels that are known as support. This terminology is indicative of prices on a chart that often acts as a floor. It prevents the price of an asset from being forcefully pushed downward. The general ability to identify a specific level of support is able to coexist with a solid buying opportunity. This is because it’s usually the area where market participants see good value and begin pushing prices higher once again.
A trendline is drawn either over pivot highs or under pivot lows to illustrate the dominant direction of price. Trendlines are basically a visual representation of both support and resistance in any time frame. They display direction and the speed of price, as well as describe patterns that occur during periods of price deflation.
Uptrends and downtrends are one of the most popular topics among technical analysts and traders. This is due to them guaranteeing that the conditions of the underlying market are working in favour of a trader’s position, not against it. Trendlines are lines that are easily recognizable and ones that traders draw on charts to connect a series of prices. The culminating line then gives the trader an idea of the direction in which an investment’s value may move to.
The examples from earlier show that a constant level keeps an asset’s price from moving both higher and lower. This static barrier is one of the most common – not to mention popular – forms of support/resistance. However, the price of financial assets will often trend upward or downward. Therefore, it is not out of the ordinary to see these price barriers change as time goes on. This is primarily why properly understanding trending and trendlines is crucial when it comes to learning about support and resistance.
Upside and downside trending
Whenever the market is trending to the upside, the formation of resistance levels occurs as the price action slows. Moreover, when it starts to pull back toward the trendline. This transpires as a result of either profit taking or near-term ambiguity for a specific issue or sector. The ensuing price action experiences a “plateau” effect or a slight drop-off in stock price. This is what effectively creates a short-term top.
A lot of traders will watch the price of a security as it leans toward the broader support of the trendline. Historically, this has proven to be an area that prevents the price of the asset from moving any lower.
However, when the market is trending downward, traders will be on the lookout for a series of declining peaks. They will try to connect these peaks together with the use of a trendline. When the price gets closer to the trendline, most traders will watch for the asset to encounter selling pressure. At which time they may enter a short position. This is because it’s an area that has a history of pushing the price downward.
The support/resistance of an identified level – whether its discovery is from a trendline or another method – is seen as stronger. Specifically, the more times the price was not able to move beyond it. A lot of technical traders will use their support and resistance levels to select strategic entry/exit points. These areas frequently represent the prices that are the most persuasive to the direction of an asset.
A majority of traders are confident at these levels in the underlying value of the asset. Therefore, the volume will often increase more than usual. This makes it considerably more difficult for traders to continue pushing the price higher or lower.
There is an additional characteristic of support/resistance that’s quite common. That being the asset’s price having the periodic inability of moving beyond a round-figure price level like $50. A good chunk of traders lacking experience have a tendency to buy or sell assets when the price is at a whole number. This is largely because there’s a higher chance that they will feel a stock is adequately valued at such levels.
Let’s take a moment to briefly elaborate on ‘price targets’ (or ‘target prices’). It is the forecasted future price level of an asset that an investment analyst or adviser states. The price target draws from assumptions concerning the various factors of the asset. These include its future supply and demand, technical levels, and fundamentals.
Many target prices or stop orders set by retail investors or large investment banks are placed at round price levels. This is in lieu of their placement being at prices such as $50.06. The placement of so many orders is generally at the same level. Because of this, these round numbers often function as strong price barriers. Suppose that the clientele of an investment bank puts in sell orders at a suggested target of $55. In this case, it would take an incredible number of purchases to consume these sales. Thus, there would be a resistance level creation.
A ‘moving average’ is a commonplace indicator when it comes to technical analysis. It assists in smoothing out price action by way of filtering out the “noise” from haphazard short-term price changes. It is a trend-following indicator because it draws from past prices. Alternatively, it is a lagging indicator. This is a measurable economic factor that changes after the economy starts to follow a particular pattern or trend.
Most technical traders integrate the overall power of several technical indicators, like moving averages, to facilitate predicting future short-term momentum. However, these traders very rarely fully realize the capability of these tools regarding support and resistance level identification.
Traders can employ the use of moving averages in a wide variety of ways. These include the following:
- Anticipating moves to the upside, when price lines cross above an essential moving average
- Exiting trades, when the price falls below a moving average
Regardless of the usage of the moving average, it regularly creates “automatic” support and resistance levels. A lot of traders will experiment with multiple time periods in their moving averages. This way, they are able to discover the one that will work best for this particular task.
In the world of technical analysis, many indicators are able to pinpoint barriers to future price action. These indicators appear intricate at first, and quite often it will take practice and experience to effectively use them. Regardless of the complexity of an indicator, the perception of the identified barrier needs to be consistent with the ones achieved with clearer methods.
The Fibonacci retracement tool, for example, is a go-to choice among a majority of short-term traders. This is because it distinctly identifies various levels of potential support/resistance. The term itself references areas of support or resistance. Fibonacci retracement levels employ the use of horizontal lines in order to indicate where possible support and resistance levels are.
There is a percentage that correlates with each level. This percentage illustrates how much of a prior move the price repeats. The official Fibonacci retracement levels are 23.6%, 38.2%, 61.8% and 78.6%. 50% is also used, though it is not officially a Fibonacci ratio.
The indicator is incredibly useful due to the fact that it can be drawn between any two significant price points. Such points include a high and a low. Then, the indicator will construct the levels between those two points.
Measuring zone significance
In keeping with the use of terms like “floor” and “ceiling,” the security is essentially a rubber ball bouncing in a room. To elaborate, it is how the ball will hit the floor (support) and then ricochet off the ceiling (resistance). A ball bouncing between the floor and the ceiling is akin to a trading instrument experiencing price unification between support and resistance zones.
Now, let’s imagine that in mid-flight, the ball transforms into a bowling ball. This extra force, should the application happen on the way up, will push the ball through the resistance level. Conversely, on the way down, it will push the ball through the support level. Regardless, extra force, or enthusiasm from the bulls or bears, is a requirement to break through the support or resistance.
Oftentimes, a support level eventually becomes a resistance level when the price makes an attempt to move back up. On the flip side, a resistance level will eventually become a support level as the price briefly falls back. Price charts permit traders and investors to visually classify areas of support and resistance. Moreover, they give clues concerning the general significance of these price levels.
To specify, they look closely at:
- The number of touches
- Any prior price move
- Whatever the volume may be at certain price levels
- The time
In the end, it’s clear to see that support and resistance levels are crucial in technical analysis. They are one of the key concepts that technical analysts use and they form the basis of many other tools.