IMPORTANCE OF SUPPORT AND RESISTANCE
There are two components to trend, direction and duration.
Markets trend in three directions, up, down and sideways. Markets do not move
consistently in one direction, but tend to be erratic. Within this erratic
behavior a trend will be present. Trends are characterized by a series of
peaks and troughs. An uptrend is a series of rising peaks and troughs, a
downtrend shows a series of descending peaks and troughs. A sideways tend is a
series of horizontal peaks and troughs, with prices moving within a range,
failing to make new highs at the top of the price range and failing to make new
lows at the bottom of the price range.
Trend duration is also made up of three time periods; major,
intermediate and minor. The major trend will have a duration of six to eight
months or longer and is best illustrated by weekly and monthly bar charts.
Within the major trend significant corrections or reversals of trend will be
present; these would be intermediate and minor trends within the major trend.
The intermediate trend lasts from three weeks to three months, and the minor
trend is anything less, from two to three weeks in duration.
Support and resistance are tools used by technicians to help
them identify and follow price trends. Horizontal lines are drawn on the bar
chart to indicate areas of support and resistance. The troughs or reaction lows
on a price chart are identified as support. Support is an area on the chart
where buying pressure overtakes selling pressure and the market reacts higher.
Usually support is identified by a previous reaction low or trough on the bar
chart. Resistance is an area on the chart where selling pressure overtakes
buying pressure and the market reacts lower. A resistance level is identified
by a previous price high or peak on the bar chart.
The concepts of support and resistance are critically
important tools used by technicians to help them identify and follow trends.
Lines are drawn on the chart to indicate areas of price support, price
resistance and price trends. In an uptrend, the resistance levels represent
pauses in the uptrend which serve to temporarily halt the price advance. In
like manner, in a downtrend, support levels will temporarily halt a price
decline. Trend lines are drawn above or below the market action depending upon
the direction of the move. During an uptrend a line would be drawn from the
first significant low to the next, extending across the page from left to
right. (see example 5) If the uptrend is valid you will find the price will
move to, or close to, the uptrend line on corrections and then move higher.
Each time a trend line is tested and holds, the more significant it becomes.
Each time a previous support or resistance level is being tested the prevailing
trend of the market is critically analyzed by the technician. Failure to exceed
a previous resistance peak in an uptrend, or to break a previous support low in
a downtrend, provides a warning that the existing trend may be changing. The
testing of these support and resistance levels form pictures on the charts that
suggest either a trend reversal or simply a pause in the prevailing trend. The
basic building blocks on which price patterns are based however, are support
and resistance.
Support and resistance levels reverse roles once they are
decisively broken . In other words if the price penetrates a resistance level,
then it will generally move upward to the next resistance level, such that the
previous resistance level will now become an area of support. The longer the
period of time that prices trade in a support or resistance area, the more
significant that area becomes. For example, if prices trade sideways for three
weeks in a support area before moving higher, that support area would be more
significant than if only three days of trading had occurred. The reason for
this is that there are now more participants in the market with a vested interest
in that support area which will hold prices up.
Once you understand the
concept of a trend, the next major concept is that of support and resistance.
You'll often hear technical analysts talk about the ongoing battle between the bulls and the bears, or the struggle between buyers (demand)
and sellers (supply). This is revealed by the prices a security seldom moves
above (resistance) or below (support).
As you can see in Figure 1, support is the price
level through which a stock or market seldom falls (illustrated by the blue
arrows). Resistance, on the other hand, is the price level that a stock or
market seldom surpasses (illustrated by the red arrows).
Why Does it Happen?
These support and resistance levels are seen as important in terms of market
psychology and supply and demand. Support and resistance levels are the levels
at which a lot of traders are willing to buy the stock (in the case of a
support) or sell it (in the case of resistance). When these trendlines are
broken, the supply and demand and the psychology behind the stock's movements
is thought to have shifted, in which case new levels of support and resistance
will likely be established.
Round Numbers and Support and Resistance
One type of universal support and resistance that tends to be seen across a
large number of securities is round numbers. Round numbers like 10, 20, 35, 50,
100 and 1,000 tend be important in support and resistance levels because they often
represent the major psychological turning points at which many traders will
make buy or sell decisions.
Buyers will often purchase large amounts of stock once the price starts to fall
toward a major round number such as $50, which makes it more difficult for
shares to fall below the level. On the other hand, sellers start to sell off a
stock as it moves toward a round number peak, making it difficult to move past
this upper level as well. It is the increased buying and selling pressure at
these levels that makes them important points of support and resistance and, in
many cases, major psychological points as well.
Role Reversal
Once a resistance or support level is broken, its
role is reversed. If the price falls below a support level, that level will
become resistance. If the price rises above a resistance level, it will often
become support. As the price moves past a level of support or resistance, it is
thought that supply and demand has shifted, causing the breached level to
reverse its role. For a true reversal to occur, however, it is important that
the price make a strong move through either the support or resistance
QFor example, as you can see in Figure 2, the
dotted line is shown as a level of resistance that has prevented the price from
heading higher on two previous occasions (Points 1 and 2). However, once the
resistance is broken, it becomes a level of support (shown by Points 3 and 4)
by propping up the price and preventing it from heading lower again.
Many traders who begin using technical analysis
find this concept hard to believe and don't realize that this phenomenon occurs
rather frequently, even with some of the most well-known companies. For example,
as you can see in Figure 3, this phenomenon is evident on the Wal-Mart Stores
Inc. (WMT) chart between 2003 and 2006. Notice how the role of the $51 level
changes from a strong level of support to a level of resistance.
n almost every case, a stock will have both a level of support and a
level of resistance and will trade in this range as it bounces between these
levels. This is most often seen when a stock is trading in a generally sideways
manner as the price moves through successive peaks and troughs, testing
resistance and support.
The Importance of Support and Resistance
Support and resistance analysis is an important part of trends because it can
be used to make trading decisions and identify when a trend is reversing. For
example, if a trader identifies an important level of resistance that has been
tested several times but never broken, he or she may decide to take profits as
the security moves toward this point because it is unlikely that it will move
past this level.
Support and resistance levels both test and confirm trends and need to be
monitored by anyone who uses technical analysis. As long as the price of the
share remains between these levels of support and resistance, the trend is
likely to continue. It is important to note, however, that a break beyond a
level of support or resistance does not always have to be a reversal. For
example, if prices moved above the resistance levels of an upward trending
channel, the trend has accelerated, not reversed. This means that the price
appreciation is expected to be faster than it was in the channel.
Being aware of these important support and resistance points should affect the
way that you trade a stock. Traders should avoid placing orders at these major
points, as the area around them is usually marked by a lot of volatility.
If you feel confident about making a trade near a support or resistance level,
it is important that you follow this simple rule: do not place orders directly
at the support or resistance level. This is because in many cases, the price
never actually reaches the whole number, but flirts with it instead. So if
you're bullish on a stock that is moving toward an important support level, do
not place the trade at the support level. Instead, place it above the support
level, but within a few points. On the other hand, if you are placing stops or short
selling, set up your trade price at or below the level of support.
