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The concepts of support and resistance are undoubtedly two of the most highly
discussed attributes of technical analysis and they are often regarded as a
subject that is complex by those who are just learning to trade. This article
will attempt to clarify the complexity surrounding these concepts by focusing
on the basics of what traders need to know. You'll learn that these terms are
used by traders to refer to price levels on charts that tend to act as barriers
from preventing the price of an asset from getting pushed in a certain
direction.
At first the explanation and idea behind identifying these levels seems easy,
but as you'll find out, support and resistance can come in various forms and it
is much more difficult to master than it first appears. (To learn more, read
Analyzing Chart Patterns and Basics Of Technical Analysis.)
The Basics
Most experienced traders will be able to tell many stories about how certain
price levels tend to prevent traders from pushing the price of an underlying
asset in a certain direction. For example, assume that Jim was holding a
position in Amazon.com (AMZN) stock between March and November 2006 and that he
was expecting the value of the shares to increase. Let's imagine that Jim
notices that the price fails to get above $39 several times over the past
several months, even though it has gotten very close to moving above it. In
this case, traders would call the price level near $39 a level of resistance.
As you can see from the chart below, resistance levels are also regarded as a
ceiling because these price levels prevent the market from moving prices
upward.
Figure 1
On the other side of the coin, we have price levels that are known as support.
This terminology refers to prices on a chart that tend to act as a floor by
preventing the price of an asset from being pushed downward. As you can see
from the chart below, the ability to identify a level of support can also
coincide with a good buying opportunity because this is generally the area
where market participants see good value and start to push prices higher again.
Figure 2
Trendlines
In the examples above, you've seen a constant level prevent 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 understanding the concepts of trending and trendlines is
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 pull back toward the trendline. This occurs as a result of profit
taking or near-term uncertainty for a particular issue or sector. The resulting
price action undergoes a "plateau" effect or slight drop-off in stock price,
creating a short-term top. (To learn more, read Track Stock Prices With
Trendlines and Short-, Intermediate- and Long-Term Trends.)
Many traders will pay close attention to the price of a security as it falls
toward the broader support of the trendline because historically, this has been
an area that has prevented the price of the asset from moving substantially
lower. For example, as you can see from the Newmont Mining Corp (NEM) chart
below, a trendline can provide support for an asset for several years. In this
case, notice how the trendline propped up the price of Newmont's shares for an
extended period of time.
Figure 3
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 learn more, check out Peak-and-Trough Analysis.)
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 prices 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.
Round Numbers
Another common characteristic of support/resistance is that an asset's price
may have a difficult time moving beyond a round price level such as $50. Most
inexperienced traders tend to buy/sell assets when the price is at a whole
number because they are more likely to feel that a stock is fairly valued at
such levels. Most target prices/stop orders set by either retail investors or
large investment banks are placed at round price levels rather than at prices
such as $50.06. Because so many orders are placed at the same level, these
round numbers tend to act as strong price barriers. If all the clients of an
investment bank put in sell orders at a suggested target of, for example, $55,
it would take an extreme number of purchases to absorb these sales and,
therefore, a level of resistance would be created.
Moving Averages
Most technical traders incorporate the power of various technical indicators,
such as moving averages, to aid in predicting future short-term momentum, but
these traders never fully realize the ability these tools have for identifying
levels of support and resistance. As you can see from the chart below, a moving
average is a constantly changing line that smooths out past price data while
also allowing the trader to identify support and resistance. Notice how the
price of the asset finds support at the moving average when the trend is up,
and how it acts as resistance when the trend is down. Most traders will
experiment with different time periods in their moving averages so that they
can find the one that works best for this specific task. (To read more, see
Exploring Oscillators And Indicators and Trading Psychology And Technical
Indicators.)
Figure 4
Other Indicators
In technical analysis, many indicators have been developed for to identify
barriers to future price action. These indicators seem complicated at first and
it often takes practice and experience to use them effectively. Regardless of
an indicator's complexity, however, the interpretation of the identified
barrier should be consistent to those achieved through simpler methods.
For example, the Fibonacci retracement tool is a favorite 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
Figure 5 how the identified levels (dotted lines) are barriers to the
short-term direction of the price. (For more on this tool, see What is
Fibonacci retracement, and where do the ratios come from?, Advanced Fibonacci
Applications and Fibonacci And The Golden Ratio.)
Figure 5
Conclusion
Determining future levels of support can drastically improve the returns of a
short-term investing strategy because it gives traders an accurate picture of
what price levels should prop up the price of a given security in the event of
a correction. Conversely, foreseeing a level of resistance can be advantageous
because this is a price level that could potentially harm a long position
because it signifies an area where investors have a high willingness to sell
the security. 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 - it prevents the price of an underlying from
moving in a certain direction.
by Casey Murphy
Casey Murphy is the senior analyst at Investopedia.com and is a graduate of the
University of Alberta School of Business. He specializes in technical analysis
and is dedicated to uncovering profitable trading opportunities. Click here to
join Casey in Investopedia's free stock picking community.