Support & Resistance

What Is Support?

Support, also known as a support level, is the price level at which an asset does not drop for a specific time frame. The support level is established by buyers entering the market when the asset's price declines. In technical analysis, a basic support level can be plotted by drawing a line across the lowest lows for the considered time period. The support line may be horizontal or inclined upwards or downwards, in line with the overall price trend. More advanced forms of support can be identified using other technical indicators and charting methods.

KEY TAKEAWAYS

• A support level indicates a price level that an asset has difficulty dropping below during a specific time frame.

• Support levels can be depicted using various technical indicators or just by drawing a line linking the lowest lows for the period.

• Using trendlines or integrating moving averages offers a more dynamic perspective of support.

What Do Support Levels Tell You?

In simple finance terms, a support level is the price point where buyers typically start buying or entering a stock. It represents a price level that a company's stock rarely falls below. When a stock's price approaches its support level, the support level either holds and is confirmed, or the stock continues to decline, requiring an adjustment of the support level to include the new lows. Support levels can be formed by limit orders or simply by the actions of traders and investors in the market.

Support and resistance levels are fundamental to technical analysis. While fundamental analysis considers a company's performance and history to predict the stock's future direction, technical analysis focuses on price patterns and trends. Traders use support and resistance levels to determine entry and exit points for trades. If a stock's price action breaks through support levels, it can be seen as a chance to buy or take a short position, based on other indicators observed by the trader. If the breach happens during an uptrend, it might even signal a potential reversal.

The Difference Between Support Level and Resistance Level

If the support level represents the price that a stock doesn't drop below, the resistance level is the price point at which a stock struggles to rise above. You can think of the support level as the floor and the resistance level as the ceiling.

Limitations of Using Support

Support is more a market idea than an actual technical indicator. There are several popular indicators that include these concepts, such as price by volume charts and moving averages, which provide more practical insights than simpler visualizations. Generally, traders prefer to see a support range rather than a single line connecting the lowest lows, as support might shift upward, causing a long position order to remain unfulfilled.

What Is Resistance?

Resistance is a fundamental aspect of technical analysis (alongside its counterpart—support). It refers to a price or price range above the current market level that hinders the upward movement of an asset. Resistance occurs when selling interest emerges over time, preventing further price increase.

Resistance can be a single price point, like the day's high or an hourly high. Alternatively, it can be a zone, a range spanning several points, such as $0.50/$1.00. A resistance zone signifies a challenge to the resistance level, which might be slightly breached but ultimately repels the price advance, maintaining the resistance level's integrity. It could also indicate a larger supply around the resistance zone, potentially signaling a downward reversal.

Resistance can be identified in any chart analysis timeframe, where a longer timeframe (daily or weekly) suggests a more significant, multi-day resistance level, while a short-term chart (hourly, 30 minutes) may reveal only minor resistance (useful for day traders).

KEY TAKEAWAYS

• A resistance level indicates a price point or price area that an asset struggles to surpass during the time frame being examined.

• A resistance level can span several points, due to numerous attempts to break above the resistance, potentially creating a resistance zone and driving prices lower.

• Trendline analysis is a straightforward yet effective method for identifying resistance areas; other mathematical techniques are also commonly used.

• Identifying resistance levels is crucial for various reasons: determining where to place a stop for a short position; setting a take-profit order for a long position, and deciding when to enter a long position upon breaking resistance (a breakout trade).

How Does Supply and Demand Affect Resistance?

Demand for an asset drives its price higher over time by absorbing the market supply. Liquidity represents the total supply and demand available at any given moment. High liquidity tends to limit overall price movement, while low liquidity can result in excessive price fluctuations, possibly causing a gap. The demand might be triggered by macroeconomic news, like a statement from a Federal Reserve official or an earnings announcement. However, after a series of gains, the demand may decrease or cease entirely, creating a resistance point or zone.

Supply can originate from various sources, such as sellers taking profit around a resistance point or zone. In another scenario, options holders might sell a large number of shares at a specific price to protect their option positions before reaching resistance. Additionally, negative macro news might prompt traders to short the market for a particular stock or asset, forming a resistance point in the process.

Resistance Is Made to Be Broken

Through technical analysis, traders can pinpoint a specific resistance point or zone. During an uptrend, this resistance zone is likely to be tested. If the trend and buying interest are strong enough to challenge the resistance point, traders may see the resistance area break, attracting more breakout buyers. Stop loss buy orders above the resistance area may also come into play, adding another source of buying and causing a clear break above the resistance.

Once the resistance point is surpassed, it's common for sellers to briefly test lower to the breakpoint to see if it holds. If it does, traders may conclude that the break of resistance is valid, and the upward trend is in play. This is an instance of a broken resistance level turning into support, known as the Polarity Principle. Once resistance is broken, it becomes support and vice versa. The importance of the new support depends on the time frame of the previous resistance. A break above a recent daily high is more bullish than a break of an hourly resistance point.

Trading Using Resistance

When a resistance point is identified, nimble traders might try to sell short when the price approaches that resistance level, such as $105/share, or take profit on existing long positions close to $105. Both actions can create new supply sources, potentially reinforcing the resistance point. Traders who shorted the stock ahead of the resistance will likely look to buy back once the expected downward move appears to be ending or ends.

As the price rises to test the resistance point, take-profit sell orders might get executed, which reduces one source of supply. If speculative short-sellers also have their orders filled, another supply source is eliminated. These short-sellers likely placed stop loss buy orders above the resistance point or zone, allowing some room for slippage. If the uptrend persists and breaks above the resistance level, those stop loss buy orders may get triggered, creating a new source of demand that drives the price higher. Alert breakout traders might enter the market on the buy side, contributing to the buying demand.

Summary

A resistance point or zone forms when prices cannot rise beyond that area. Resistance levels can appear on short-term or long-term charts, with long-term resistance levels being more significant in determining the next move of the security. Technical analysis or visual inspection can identify resistance levels using tools like trendlines, horizontal lines, moving averages, and Bollinger Bands.

In terms of trading, resistance levels present various opportunities. You could choose to buy into a resistance zone, anticipating a breakthrough, or enter a long position after a breakout has occurred. Alternatively, you could sell into the resistance zone and go short, believing that the resistance will hold and prices will drop. Regardless of your approach, when prices approach a resistance zone, it's crucial to pay attention to price action and potential opportunities.