Support and Resistance

Hi there,

As i said in my last article, the next major concept is that of ‘support’ and ‘resistance’. These are two terms that are used very frequently by stock analysts.

To put in very simple terms -Support is the price level below which a stock is not expected to fall. Resistance, on the other hand, is the price level which a stock is not expected to surpass.

You also need to go thru the next topic on ‘volume’ to fully understand the concept of support and resistance.

SUPPORT AND RESISTANCE

Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic is that, when the price declines, there will be more demand for the particular share. By the time the price reaches a particular level (called support level), it is believed that demand will overcome supply and prevent the price from falling below support

Resistance is just the opposite of ‘support’. A Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic behind the theory is that , as the price advances , sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches a particular level (called the resistance level) it is believed that supply will overcome demand and prevent the price from rising above resistance.

In the book “Trading for a Living,” Dr. Alex Elder gives a simple, but effective image of support and resistance – “A ball hits the floor and bounces. It drops after it hits the ceiling. Support and resistance is like a floor and a ceiling, with prices sandwiched between them.” When a stock’s price has fallen to a level where demand at that price increases and buyers begin to buy, this creates a “floor” or support level. When a stock’s price rises to a level where demand decreases and owners begin to sell to lock in their profits, this creates the “ceiling” or resistance level.

Shown below is a typical share price movement on a chart. The two lines drawn horizontally are called trendlines. The red arrows illustrate ‘resistance’ or ‘ceiling’. As you can observe, the price fails to pass above that particular level. Similarly the blue arrows illustrate ‘support’ level or ‘floor’ beyond which the price fails to fall.

HOW TO RECOGNIZE SUPPORT AND RESISTANCE.

You can identify support and resistance levels by studying a chart. (See the chart above) Look for a series of low points where a stock falls to this level, but then falls no further. This is a support level. When you find that a stock rises to a certain high, but no higher, you have found a resistance level.

The more times that a stock bounces off support and falls back from resistance, the stronger these support and resistance levels become. It creates a self-fulfilling prophecy. The more often it happens, the more likely it is to happen again. The more those historical patterns repeat themselves, the more traders “know,” and the more confident they become in forecasting the future behavior of the stock.

ROUND NUMBERS

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 Rs 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.

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 share price moves toward this point because it is unlikely that it will move past this level.

THE PSYCHOLOGY BEHIND SUPPORT AND RESISTANCE

To understand the psychology behind support and resistance, we need to first categorize market participants. Market participants can typically be classified into:

1) The longs -traders who have a ‘BUY’ position and stand to profit if prices increase.

2) The shorts -traders who have a ‘SELL’ and stand to profit if prices decrease.

3) Traders who got out of their previous positions prematurely.

4) Traders who are undecided on which side of the market to be on and are looking for entry points either on the short side or the long side.

Assuming now, that prices start advancing from a support area, the longs who bought around this area would have regretted not buying more. So, every time prices come back to the support area, they would likely decide to buy more.

Traders on the short side however, would have likely realized that they are on the wrong side of the market and they would be hoping for prices to come back to the support area where they entered their short positions so that they can get out and at least break even.

The traders who had previously got out of their long positions at the support area would likely be annoyed at themselves for getting out too early and would thus be looking for a chance to get into a position again at or around the support area.

The traders who were previously undecided on which side they wanted to be on would likely decide to want to enter the market on the long side after observing the advance in prices. As such, they would be looking to enter whenever there is a good buying opportunity, which is at or around the support area.

These traders now all have the same resolve to buy should a good opportunity present itself and should prices decline to the support area, there would be buying taking place by all four groups which would result in prices being pushed up.

ROLE REVERSAL

Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level may become resistance. If the price rises above a resistance level, it may often become support. As the price moves past a level of support or resistance, it is believed 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.

In 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.

NUMERICAL WAY TO CALCULATE SUPPORT AND RESISTANCE

There are many ways to calculate levels of support and resistance (Pivot point method, Moving averages, Fibonacci numbers etc). One of the most common is to use a series of formulas to calculate “pivot points”, described herein

Calculate the pivot point as follows, using the previous day’s high, low, and close:

  • Pivot or P = (High + Low + Close) / 3
  • Calculate the first support point (S1)      = (P x 2) – H
  • Calculate the second support point (S2)  = P – (High – Low)
  • Calculate the first resistance point   (R1)  = (P x 2) – Low
  • Calculate the second resistance point( R2)     = P + (High – Low)

Adjusted Pivots

Many traders adjust their value for P as follows:

  • O = Today’s Opening Price
  • P = O + (H + L + C) / 4  (where H, L & C are from the previous day’s stock details)

Pivot points are short-term indicators, and ultimately it is the trader’s responsibility to use them wisely, in conjunction with other confirming indicators. Pivot points keep changing everyday since it’s based on daily data.

That’s about support and resistance. in the ent article we will discuss about the importance of ‘volume’ in technical analysis.

till then ,

have a nice day !!

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  1. Trendlines

2 Responses to “Support and Resistance”

PRASHANTH AV

March 5, 2014 at 5:15 pm

EXCELLENT EXPLANATION.

Fahim

June 16, 2016 at 2:23 pm

Nice explanation

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