Chapter 4-5 Support and Resistance Levels

Support and resistance levels are the backbone of technical analysis.  These support and resistance levels can be found on almost any stock chart, including intra-day, weekly, monthly, yearly, and so on.  As a result, understanding and identifying support and resistance levels are crucial to just about all types of trading.

Supply and Demand

Support and resistance and their impact on price movement are similar to that of supply and demand.  Prices are driven downward by dramatic increases in supply due to excessive selling.  Moreover, prices are pushed up by excessive buying as demand rapidly increases.  Just like in basic economics, as supply increases, prices decline and as demand increases, prices rise.  Furthermore, when supply equals demand, prices consolidate and trade relatively sideways, between support and resistance levels, as buyers and sellers attempt to tip the scales in a particular direction.

Support

A support level acts as a floor, preventing price from falling further.  This level forms due to the sudden increase in demand.  The abrupt rise in demand occurs due to the flood of buyers entering into the fray.  Naturally, buyers become more inclined to buy as the price gets cheaper, while sellers become increasingly hesitant to sell or short.  This “oversold” mentality forms a potent price barrier, which often causes the stock price to make a 180-degree turn and ascend to higher prices.

However, if the support level fails to hold, a breakdown occurs indicating supply is still much greater than demand.  As a result, price will continue to fall, indicating weakness.  This occurs due to a new desire to sell, in conjunction with a lack of effort to buy.

In other words, at a support level a battle occurs between buyers and sellers.  A portion of traders are long and vested in maintaining the level, with the hope that price eventually rises.  Moreover, some of those who were short are convinced that the level will not break and cover as they fear the price will begin to rise.  However, on the other side of the coin, there are those who are vested in breaking through the level, so that the price may continue to fall.  This “tug of war” creates a pivot point (a price of key interest that can potentially determine the direction of the next move).  If price penetrates through the support level, new shorts will enter and buyers will exit, as this indicates weakness.  Inversely, if the level holds and price begins to ascend away from the support level, an increased amount of buyers will enter, as shorts will look to cover.

Resistance

Resistance has an inverse relation to support.  A resistance level acts as a ceiling, preventing price from ascending higher.  This level forms due to the sudden increase in supply.  The abrupt rise in supply occurs as a flood of sell and short orders seek execution.  Naturally, those who are long become more inclined to sell as the price gets more expensive, while new buyers become increasingly hesitant to buy.  Moreover, shorts are enticed to enter as the price gets more costly.  This “overbought” mentality forms a potent price barrier, which often causes the stock price to make a 180-degree turn and descend to lower prices.

However, if the resistance level fails to hold, a breakout occurs indicating demand is still much greater than supply.  As a result, price will continue to rise, indicating strength.  This occurs due to a new desire to buy, as well as a lack of effort to short or willingness to sell

In other words, at a resistance level a battle occurs between buyers and sellers.  A portion of traders are short and vested

in maintaining the level, with the hope that the price eventually descends.  Moreover, some of those who were long are convinced that the level will not break and sell as they fear the price will begin to decline.  However, on the other side of the coin, there are those who are vested in breaking through the level, so that the price may continue to rise.  This “tug of war” creates a pivot point.  If price penetrates through the resistance level, new buyers will enter, selling will cease, and shorts will cover, as this indicates strength.  Inversely, if the level holds and price begins to descend away from the resistance level, an increased amount of shorts will enter, as buyers will look to sell.

Support Equals Resistance

When a support level is broken, that level typically then becomes resistance.  This occurs because that break of support signals that the forces of supply have overcome the forces of demand.  Thus, if the price returns to that level, there will likely be an increase in supply, which will act as resistance.

The same is true for resistance; once resistance is penetrated, that level is likely to turn into support.  This is caused by the break of resistance which signals that the forces of demand have overcome the forces of supply.  Therefore, if the price returns to that level, there will likely be an increase in demand, which will act as support.

It is common to see price return to a level once broken.  Therefore, do not panic as price tests a previous level.  Validity will only increase a signal as traders are reminded of the price barrier.

Locating Levels

Identifying where key price levels on a chart may lye will greatly assist your trading.  Knowing where support and resistance levels commonly are can prevent you from entering a bad trade or exiting too late from a profitable one.  Often support and resistance are found at key price points and technical levels, such as highs and lows, figures and halves, trendlines, and moving averages.  When prices reach levels such as these, effective barriers of support and/or resistance form.

Trendlines

Trendlines form all over as stock prices rarely stay still.  Because a stock tends to trend up or down, it is common to see a level change in price over time.  In an uptrend, many traders will analyze how a stock reacts when price falls towards a trendline.  If the level holds, then that trendline can be considered a level of support.  Inversely, in a downtrend, if price rises but is held below a trendline it is considered a level of resistance.  By connecting a series of rising peaks (uptrend) or declining peaks (downtrend) the location of important support and resistance levels become evident.

Moving Averages

A common technical indicator, called moving averages, often also creates support and resistance levels.  Like trendlines, moving averages change in price over time, thus the levels of support or resistance move.  If price stays above a moving average and is unable to cross below, then that moving average is considered support.  On the contrary, if the price stays below a moving average and is unable to cross above, then that moving average is regarded as resistance.

High and Lows

Support and resistance levels are also usually found at highs and lows.  Intra-day, weekly, yearly, and all-time highs and lows are common levels of support and resistance.  The longer price is unable to break through a particular level, the more valid that level becomes.  Therefore, yearly levels are much harder to break through than intra-day levels of support or resistance.

Figures and Halves

Important levels of support and resistance are also commonly found at figures (example: $49.00) and halves (example:  $49.50).  The main reason for this is convenience.  Institutional traders, investment banks, and hedge funds, which all trade in very large share amounts, often place limit orders at figures and halves on the limit order book, ECNs, or a combination of the two.  They do this simply because it is easier to keep track of price targets and stop orders, as well as monitor profits and losses.  These very large stagnant orders at figures and halves typically take a substantial amount of time to be completely filled.  Thus, as time passes, a level forms as the price is unable to penetrate through the large limit order.  With the level in place, opinions form on whether price will ever break through the level.

As a result, using levels such as those created by the various ways described before can produce very profitable setups, including breakouts and reversals.  Since support and resistance levels are so common, it is imperative to only focus on setups at levels that suite your reward to risk ratio.  Stocks that commonly trade with high volatility and large ranges will typically have violent breakouts or reversals at these support and resistance levels.  While stocks that are typically slower moving, with lower volatility, will have smaller less eventful breakouts or reversals.  Find stocks that you are comfortable with and that meet your suitability.

Break or Hold?

You will find that stocks, as well as the overall market, during a particular day will tend to act similar at support and resistance levels.  On high volume and high volatility days most stocks will breakout through support and resistance levels many times over in the day.  However, on low volume and low volatility days most stocks fail to break any major levels and trade in a channel between support and resistance.

Time of day (or time of year for weekly/yearly levels) also should be considered when determining whether a stock will break or hold a level.  Volume and volatility are high early in the trading day, as well as towards the close; these conditions aid in the breaking of support and resistance levels.  However, towards the middle of the trading day, when volume and volatility severely drop off, support and resistance levels tend to hold firm.  Keeping this in mind will help you determine which scenario is more likely to take place.

Support and Resistance Areas

Sometimes finding an exact price at which a level of support or resistance lies on a chart is not possible.  Instead, identifying an area of support or resistance can be more useful when no one price point is relevant.  Often when a chart is volatile or choppy, a level does not form a barrier at any one price.  When this is the case, look for a general area where price noticeably has difficulty breaking through.  This will help identify a more reliable support or resistance.

Conclusion

Ultimately, using support and resistance levels allow you to create a detailed game plan for a particular stock and/or the overall market.  This “blueprint” will help you determine the proper strategy, whether it be to buy, sell, hold, short, or avoid completely.  Therefore, identifying, preparing, and trading with support and resistance levels will greatly aid in your pursuit of profitability and consistency.

Support

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  • Support acts as a floor, preventing price from falling further.

 

  • As price approaches a support level, demand increases and often exceeds supply, preventing price from falling further.
  • Price finds support because buyers become more inclined to buy as price gets cheaper, while sellers become increasingly hesitant to sell or short.

Resistance

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  • Resistance acts as a ceiling, preventing price from ascending higher.
  • As price approaches a resistance level, supply increases and often exceeds demand, preventing price from rising further.
  • Price finds resistance because shorts seek execution as price gets more expensive.
  • Another reason why price finds resistance is due to those who were long look to sell as price gets expensive, while new buyers become increasingly hesitant to enter.

 

Support = Resistance

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  • When support is broken it becomes resistance.
  • Because the break of support signals that the forces of supply have overcome the forces of demand; if the price returns to that level, there will likely be an increase in supply, which will act as resistance.
  • Inversely, when resistance is broken it becomes support.
  • Because the break of resistance signals that the forces of demand have overcome the forces of supply; if the price returns to that level, there will likely be an increase in demand, which will act as support.

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