Support and Resistance Basics

Support and resistance are two fundamental concept in technical analysis that the movement of the price of a security will tend to stop and reverse at certain predetermined price levels.

In stock market prices move because of supply and demand. When demand is greater than supply, prices rise. When supply is greater than demand, prices fall. Sometimes, prices will move sideways as both supply and demand are in balanced state.

IMPORTANT LOGIC 

Technical analysts use support and resistance levels to identify price points on a chart where the probabilities favor a pause or reversal of a prevailing trend. 

Support occurs where a downtrend is expected to pause due to a concentration of demand.

Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply. 

Market psychology plays a major role as traders and investors remember the past and react to changing conditions to anticipate future market movement.

Support and resistance areas can be identified on charts using trendlines and moving averages.

What Is Support?

Support can be a price level on the chart or a price zone. Support is an area on a price chart that shows buyers’ willingness to buy. It is at this level that demand will usually overwhelm supply, causing the price decline to halt and reverse.

A support level is a price level where the price tends to find support as it is going down. This means the price is more likely to “bounce” off this level rather than break through it. However, once the price has passed this level, by an amount exceeding some noise, it is likely to continue dropping until it finds another support level.

What is resistance

A resistance level is the opposite of a support level. It is where the price tends to find resistance as it is going up.

This means the price is more likely to “bounce” off this level rather than break through it. However, once the price has passed this level, by an amount exceeding some noise, it is likely that it will continue rising until it finds another resistance level.

The Basics

Support and resistance can be found in all charting time periods; daily, weekly, monthly. Traders also find support and resistance in smaller time frames like one-minute and five-minute charts. But the longer the time period, the more significant the support or resistance. To identify support or resistance, you have to look back at the chart to find a significant pause in a price decline or rise. Then look forward to see whether a price halts and/or reverses as it approaches that level. It has been noted above, many experienced traders will pay attention to past support or resistance levels and place traders in anticipation of a future similar reaction at these levels.

Technical analysis is not an exact science, and sometimes price will dip below support levels or reverse before it gets to the prior support level. The same is true for resistance: Price may reverse before it gets to the prior resistance level or break above it. In each case, flexibility is required in interpreting these chart patterns. This is why support and resistance levels are sometimes referred to as zone.

Support levels are on the flip side of the coin. Support refers to the price level on a chart where equilibrium is reached. This means that demand has increased to match supply. This causes the decline in the price of the asset to halt; therefore, price has reached a price floor. As you can see from the chart below, the horizontal line below price represents the price floor. You can see by the blue arrows underneath the vertical line that price has touched this level four times in the past. This is the level where demand comes in, preventing further declines. This is support.

Trendlines

The examples above show that a constant level prevents an asset’s price from moving higher or lower. This static barrier is one of the most popular forms of support/resistance, but the price of financial assets generally trends upward or downward, so it is not uncommon to see these price barriers change over time. This is why the concepts of trending and trendlines are important when learning about support and resistance.

When the market is trending to the upside, resistance levels are formed as the price action slows and starts to move back toward the trendline. When price is moving against the prevailing trend, it is called a reaction. Reactions can occur for a large variety of reasons, including profit taking or near-term uncertainty for a particular issue or sector. The resulting price action undergoes a “plateau” effect, or a slight drop-off in stock price, creating a short-term top.

On the other hand, when the market is trending to the downside, traders will watch for a series of declining peaks and will attempt to connect these peaks together with a trendline. When the price approaches the trendline, most traders will watch for the asset to encounter selling pressure and may consider entering a short position because this is an area that has pushed the price downward in the past. To be a valid trendline, price needs to touch the trendlines at least three times. Sometimes with stronger trendlines, price will touch the trendline several times over longer time periods. Also, in an uptrend, the trendline is drawn below price, while in a downtrend, the trendline is drawn above price.

The support/resistance of an identified level, whether discovered with a trendline or through any other method, is deemed to be stronger the more times that the price has historically been unable to move beyond it. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit points because these areas often represent the prices that are the most influential to an asset’s direction. Most traders are confident at these levels in the underlying value of the asset, so the volume generally increases more than usual, making it much more difficult for traders to continue driving the price higher or lower.

Moving Averages

Most technical traders incorporate the power of various technical indicators, such as moving averages, to aid in predicting future short-term momentum. In fact, people who find it difficult to draw trendlines often will substitute them for moving averages. As you can see from the chart below, a moving average is a constantly changing line that smooths out past price data, allowing for an easier identification of support and resistance. Notice how the price of the asset in the chart below finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down.

Traders can use moving averages in a variety of ways, such as to anticipate moves to the upside when price lines cross above a key moving average, or to exit trades when the price drops below a moving average. Regardless of how the moving average is used, it often creates “automatic” support and resistance levels. Most traders will experiment with different time periods in their moving averages so that they can find the one that works best for their trading time frame.

Other Indicators

In technical analysis, many indicators have been developed and are still being developed to identify barriers to future price action. Some indicators are plotted on price charts, while others are plotted above or below price. These indicators can often seem complicated at first, and it takes practice and experience to learn to use them effectively. But regardless of how complex an indicator appears, its use and interpretation are often no different from that of other indicators created through simpler methods like calculating moving averages and drawing trendlines.

The “golden ratio” used in the Fibonacci sequence, also observed repeatedly in nature and social structure.

For example, the Fibonacci retracement is a favorite tool among many short-term traders because it clearly identifies levels of potential support/resistance. The reasoning behind how this indicator calculates the various levels of support and resistance is beyond the scope of this article, but notice in the chart below how the identified levels (dotted lines) are barriers to the short-term direction of the price.

Trading Ranges

Trading ranges can sometimes occur. These are areas where support and resistance levels are relatively close and price bounces between two levels for a period of 

Support and Resistance Reversals

A previous support level will sometimes 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 that 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 psychology drives technical indicators.

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 on 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 than at a loss.

Time

Support and resistance zones seen in longer time frame charts such as weekly or monthly charts are often more significant than those seen in shorter time frame charts such as the one-minute or five-minute chart.

 Some investors dismiss support and resistance levels entirely because they say that the levels are based on past price moves, offering no real information about what will happen in the future. But all of technical analysis is based on using past price action to anticipate future price moves; therefore, this is an argument for dismissing technical analysis entirely.

The Bottom Line

Support and resistance levels are 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 the floor under price, and a resistance level, which can be thought of as the ceiling above price. Prices fall and test the support level, which will either hold, and the price will reverse to the upside, or 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 indication of where price declines are likely to halt. Conversely, foreseeing a level of resistance can be advantageous because it will alert traders to be vigilant as price approaches this area for a likely reaction in price. 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: The trader is looking for an indication that the price of a security will likely react in a certain manner as it approaches and touches a recognized price level.