This is revealed by the prices a security seldom moves above
(resistance) or below (support).
Figure 1
As you can see in Figure 1, support is the price level
through which a stock or market seldom falls (illustrated by the blue arrows).
Resistance, on the other hand, is the price level that a stock or market seldom
surpasses (illustrated by the red arrows).
Why Does it Happen?
These support and resistance levels are seen as important in
terms of market psychology and supply and demand. Support and resistance levels
are the levels at which a lot of traders are willing to buy the stock (in the
case of a support) or sell it (in the case of resistance). When these
trendlines are broken, the supply and demand and the psychology behind the
stock's movements is thought to have shifted, in which case new levels of
support and resistance will likely be established.
Round Numbers and Support and Resistance
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 $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.
Role Reversal
Once a resistance or support level is broken, its role is
reversed. If the price falls below a support level, that level will become
resistance. If the price rises above a resistance level, it will often become
support. As the price moves past a level of support or resistance, it is
thought 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. (For
further reading, see Retracement Or Reversal: Know The Difference.)
Figure 2
For example, as you can see in Figure 2, the dotted line is
shown as a level of resistance that has prevented the price from heading higher
on two previous occasions (Points 1 and 2). However, once the resistance is
broken, it becomes a level of support (shown by Points 3 and 4) by propping up
the price and preventing it from heading lower again.
Many traders who begin using technical analysis find this
concept hard to believe and don't realize that this phenomenon occurs rather
frequently, even with some of the most well-known companies. For example, as
you can see in Figure 3, this phenomenon is evident on the Wal-Mart Stores Inc.
(WMT) chart between 2003 and 2006. Notice how the role of the $51 level changes
from a strong level of support to a level of resistance.
Figure 3
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. This is most often seen when a stock is trading in a
generally sideways manner as the price moves through successive peaks and
troughs, testing resistance and support.
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 security moves toward this point because it is
unlikely that it will move past this level.
Support and resistance levels both test and confirm trends
and need to be monitored by anyone who uses technical analysis. As long as the
price of the share remains between these levels of support and resistance, the
trend is likely to continue. It is important to note, however, that a break
beyond a level of support or resistance does not always have to be a reversal.
For example, if prices moved above the resistance levels of an upward trending
channel, the trend has accelerated, not reversed. This means that the price
appreciation is expected to be faster than it was in the channel.
Being aware of these important support and resistance points
should affect the way that you trade a stock. Traders should avoid placing
orders at these major points, as the area around them is usually marked by a
lot of volatility. If you feel confident about making a trade near a support or
resistance level, it is important that you follow this simple rule: do not
place orders directly at the support or resistance level. This is because in
many cases, the price never actually reaches the whole number, but flirts with
it instead.
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