March 17, 2011, 12:18 p.m.
posted by handcore
Support and Resistance
Knowing how to recognize and profit from levels of support and resistance can improve your trading success.
In trading, supply and demand is easy to spot. As the price of a stock or other investment drops, it reaches a price at which enough traders and investors are willing to buy, and its price stops falling and even starts to head back up as the buying starts. Conversely, as the price of a stock or investment increases, it reaches a price at which no trader or investor is willing to buy, and the excess supply of stock causes the price to stop increasing and head back down. By learning to identify levels of support and resistance and by understanding the implications when those levels are broken, you can improve the results of both your technical trading and your fundamental analysis investing.
An old saying in technical analysis circles is "Stocks don't have memory, but people do." People's memories, not to mention psychology, generate levels of support and resistance. For example, many people who buy and sell stocks can't stomach losing money on an investment. Although it would be better to sell a losing trade and invest the proceeds in a more profitable endeavor, these people hang on to their stock until it reaches their original purchase price and only then do they sell. That original purchase price is one form of resistance. Similarly, a company might have a well-known buy price, whether it's based on the dividend the company pays, a previous low, or the company's inherent value. When the stock price drops to that buy price, everyone jumps in and buys, and the price goes back up. Figure shows obvious examples of both support and resistance.
Examples of support and resistance in a StockCharts.com Chart School bar chart
Moving averages [Hack #51] can also act as levels of support and resistance. Many traders consider the price moving below the moving average as a sell sign. Any change in opinion is a psychological barrier, so prices often have difficulty moving below a widely acknowledged sell sign, such as the price-moving average crossover. Therefore, when the price is higher than the moving average, the value of the moving average becomes a support level. For example, in Figure, IBM's price dropped in the middle of February. However, as the price approached the 50-day moving average, it started to level out. For two weeks the price hovered just above the 50-day moving average, which provided strong support against a further drop in price. However, on March 8 the price dropped below the moving average. As soon as the sell signal triggered and the support level was broken, traders acted on the sell signal and the price continued to drop rather rapidly. Similarly, a moving average represents resistance when the price is below the moving average. The price crossing higher than the moving average is a buy sign, which is a psychological barrier to further increases. However, if that resistance level is breached and the price rises above the buy sign, the price often increases rapidly.
When the price breaks through a level of support or resistance, it often continues its trend. However, as soon as the price breaks through a level of resistance, it becomes difficult for the price to drop back below that level. What is the difficulty in dropping below a particular price called? Support. Therefore, the price that just before was a level of resistance has magically turned into a level of support! If you think about it, a trader isn't much different from a dog that has run through its electric fence. With this image in mind, it's easy to understand why these role reversals are quite common. In addition, prices trading near a level for a long time indicates that the level is a strong one. However, the stronger the level is, the higher the chance of that level reversing roles. That is, if the price breaks through a strong level of resistance, it is more likely that the price will turn into a strong level of support.