Support and Resistance in Technical Analysis
Stock market technical analysis has many tools, techniques, and indicators that are used for price forecasting but one of them is particularly important: the concept of support and resistance levels.
In this article we’ll explain how are those support and resistance levels supposed to work and how can you find them and why are they important.
Table of Contents
What is Support in Technical Analysis?
A support price level simply means the lowest possible price of an asset.
A support level is determined by two or more of the lowest points of an asset’s price history during a certain period. An example of a support level would be a line on the annual price graph that crosses $50 and $55 price points. Those are two minimum prices of security which were observed throughout the year and it’s believed that it’s quite unlikely that the price would fall below those “support” levels in the near future.
If the price does fall below $55 or $50, it’d signify that the general trend might change its direction soon.
The theory behind support levels states that, usually, a price of an asset would “bounce” off those low levels and more bounces mean a stronger support power. The biggest and strongest price support levels for old companies are the historical ones.
To determine the support level, just look at a price graph for a time frame you’re interested in and find at least two the lowest price points. Then, draw a line from one point to another (most of the modern trading platforms can do it automatically).
Looking at a bigger picture by using a longer period of time might often help to make a good decision. Even if you’re a day trader, it’s very important to know the lowest price levels for a last month and year too, because when those levels from the different time frames cross each other, the market might give an additional support power to an asset price due to the fact that the price enters the territory of those traders who operate long-term.
Example of a Support Level
Let’s take the Coca-Cola company (NYSE: KO) and it’s splits-adjusted stock price graph provided by stockcharts.com as an example.
Historically, from a major bull trend from 1980 to 1998, the price of the Coca-Cola company moved in a relatively stable manner. For all the years its stocks were traded, excluding the period before 1996, there were just 2-3 support price levels at about $13 per share each (based on the splits adjusted price data). The price almost never went outside this boundary after 1996, thus it’s very unlikely that the price will fall under this point in the future.
Arguably, the Coca-Cola company might not be the best example here because, from 2009, its bull price trend looks quite strong.
What is Resistance in Technical Analysis?
The resistance concept is the exact opposite of the support level concept.
The resistance means the highest price level, some kind of a roof which a price of an asset can’t easily penetrate. To visualize the resistance level, just find at least two of the highest points of the price history in a time frame you’re interested in and draw a straight line that connects them. After you do this, it would be easy to see what price peaks might be hard to conquer in the future.
Example of the Resistance Level
We’ll look at the Bank of America Corp (NYSE: BAC) stock price history to see how the resistance levels can be determined. Let’s take the recent 1-year graph and here we don’t have to adjust the price for splits as there were just 3 of them in 1986, 1997 and 2004.
It’s quite clear that there is an obvious resistance level at somewhere close to $30-$31, the price touched this level twice in 2019.
Note that a brief exit out of the support or resistance levels is acceptable, it’s actually quite common for a price of an asset to push those levels by 0.1%-1% and this wouldn’t be considered to be a break of any of those levels level or a change in price trend.
What are the Psychological Price Levels?
To some extent, the resistance and support levels are psychological too and they can be referred to as psychological levels occasionally. These historical highs and lows are important for people as they feel that they are hard to break: investors and traders have tried to break them before but failed, that strengthens the assumption that support and resistance levels are real.
Psychological price levels are also those beautiful rounded prices of $10, $50, $100 or anything that, due to our human nature, looks meaningful. The price can even be $666 and it would have more meaning for many people than $668. Some people think that those price levels have additional power and they have to be treated differently.
The most interesting thing happens when the resistance or the support level is also the psychological level, something like 100, then it’s a combination of factors which together supposed to form a very solid price bound.
What is the Price Corridor and a Trend Line?
In some cases, when the resistance and support price lines are almost parallel, the distance between those lines is called a price corridor. It’s like a tube within which an asset price would usually move. This corridor usually points to a certain direction, which indicates a general trend direction.
Why does This Theory Work?
One common explanation of why the support and resistance concept works in practice is tightly connected with demand. As soon as the price gets closer to an important level, most of the market participants know that and they tend to assume that everybody would push the price back, and that’s what actually happens very often in the real world.
Many traders place their automatic buy and sell orders somewhere around those price points and, as soon as an asset price touches them, the trade volume tends to increase. Traders see this activity and it leads to uncertainty among some of them. Others would start to watch the market closely and prepare to make a move in case of a price breaks out of its bounds.
This theory works because a big part of trading, especially an active day trading, is about human psychology.
There is a very common idea in the minds of many traders, investors, and economists that there is a so-called “fair price” for every asset. The job of the free market is to determine this price at any particular moment by free trade, but, to do so, prices must move freely. Those support and resistance levels are seen as some sort of obstacles which were tested before and thus they are harder to overcome. If the price can’t jump over a particular level (or fall below one, in the opposite case), maybe a “fair price” of an asset is somewhere inside this boundary after all?
A number of people would always expect that asset prices would bounce off their historical levels and they would bet money on it, therefore those resistance and support levels are not just some points on the graph, there are real people with real money behind them and they are ready to defend the old trends.
Why are Support and Resistance Levels Important?
This concept is the basis of the technical analysis, it’s as important as the Elliott wave principle.
Whether you believe in this concept or not, any active trader and even an investor should learn about it due to the fact that others do follow those signs, and, as mentioned above, they are ready to bet real money on those levels. Even in the long run, if you just follow a buy-and-hold strategy where you place your safety stop-loss orders, what price should they be placed at? What would be the price at which you would have to admit that you were wrong with your forecast and close your positions? There should be a level, and, when you determine it, it might be a wise idea to take into account the support and resistance levels.
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