The concepts of support and resistance are undoubtedly two of the most highly discussed attributes of technical analysis. Part of analyzing chart patterns, these terms are used by traders to refer to price levels on charts that tend to act as barriers, preventing the price of an asset from getting pushed in a certain direction. 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 the concept is more difficult to master than it first appears.
Defining Support and Resistance
Support is a price level where a downtrend can be expected to pause due to a concentration of demand. As the price of a security drops, demand for the shares increases, thus forming the support line. Meanwhile, resistance zones arise due to a sell–off when prices increase.
Once an area or “zone” of support or resistance has been identified, it provides valuable potential trade entry or exit points. This is because, as a price reaches a point of 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 direction – until it hits the next support or resistance level.
Most forms of trades are based on the belief that support and resistance zones will not be broken. Whether price is halted by the support or resistance level, or it breaks through, traders can “bet” on the direction and can quickly determine if they are correct. If the price moves in the wrong direction, the position can be closed at a small loss. If the price moves in the right direction, however, the move may be substantial.
Measuring the Significance of Support and Resistance Zones
Remember how we used the terms “floor” for support and “ceiling” for resistance. Continuing the house analogy, a security is like 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.
Often, a support level will eventually 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. More specifically, they look at:
Number of touches. The more times the price tests a support or resistance area, the more significant the level becomes. When prices keep bouncing off a support or resistance level, more buyers and sellers notice and will base trading decisions on these levels.
Preceding Price Move. Support and resistance zones are likely to be more significant when they are preceded by steep advances or declines. For example, a fast, steep advance (or uptrend) will be met with more competition and enthusiasm and may be halted by a more significant resistance level than a slow, steady advance. A slow advance may not attract as much attention. This is a good example of how market psychologydrivestechnicalindicators.
Volume at Certain Price Levels. The more buying and selling that has occurred 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 strong activity occurs under high volume and the price drops, a lot of selling will likely occur when price returns to that level, since people are far more comfortable closing out a trade at the breakeven point rather than at a loss.
Time. Support and resistance zones become more significant if the levels have been tested regularly, over an extended period of time.
The Bottom Line
Support and resistance levels are one of the key concepts used by technical analysts and form the basis of a wide variety of technical analysis tools. The basics of support and resistance consist of a support level, which can be thought of as a floor under trading prices, and a resistance level, which can be thought of as the ceiling. Prices fall and test the support level, which will either “hold,” and price will bounce back up, or the support level will be violated, and the price will drop through the support and likely continue lower to the next support level.
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, signifying 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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