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Introduction
The concepts of support and resistance are among the most important in technical analysis. They represent psychological barriers that can impede a stock's move, but can also be utilized to anticipate new information. When making a visual assessment of a stock chart, a solid understanding of support and resistance can help investors determine entry and exit points for profitable trading.
Support
Simply, support is a floor price that the market for a stock has shown a hesitation to break through in the past. The more times a stock touches this floor price, the stronger the support is said to be. It can be defined by a low point in trading, or by a period of price consolidation.
Chart 1 - The blue line represent a floor price that this stock has bounced off of numerous times, making it a level of good support.
It is not uncommon for support prices to occur at even dollar values, as these tend to be psychological barriers for market participants. The longer the time period that the level of support has held up, the more important it is. Stocks that penetrate strong levels of support often head lower.
Defining support is relatively simple. Looking at the stock chart, find areas where the stock has traded sideways for a period or, a low point in recent trading. If the stock has pushed the floor price on numerous occasions, then that level of support will be strong as it holds greater significance in the memories of investors.
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Chart 2 - Once the level of support was penetrated the stock headed lower.
From an investor's standpoint, the level of support can serve as an exit point from a long position, or an entry point for a short position. If a stock penetrates a support level after a period of consolidation and general pessimistic trading, it often heads lower. Owners of stocks that are testing support should be wary of the downside risk that is evident, and may want to exit the position if that support level is violated. Short sellers should look at these situations as an opportunity to make a successful trade on an abnormal downward move.
As a caveat, however, it should be recognized that support often serves as a point for negative psychology to reverse. If a stock is undervalued, it often bounces off of support and reverses a downtrend. While this can happen, it is more the exception than the rule. In these situations, be sure that the bounce actually breaks the market's pessimism and is not just a feeble attempt to dissuade the inevitable downward trend.
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Resistance
Resistance is just the opposite of support. Instead of a floor price, it is a ceiling that the market has shown an unwillingness to trade above. For a stock to break through resistance often requires a dramatic shift in psychology, often brought by positive new information.
To find the line of resistance, look at the stock chart and seek out high points or trading ranges. High points provide an upper limit of value for the stock, and trading ranges define an area where the market had a strong consensus on the value of the company. As with support, the more often a stock touches the line of resistance, the stronger that ceiling is. Again, resistance often forms at even dollar values as they sit well in the minds of investors.
Chart 3 - This stock touched against the $38 level three times over three months, but was never able to break through. The market was unwilling to pay more than this price based on all the information it had about the company.
Investors want to pay attention to a stock's resistance point, because a break through that point is often followed by an uptrend. Theoretically, resistance represents the maximum the market is willing to pay for the company. If the market becomes willing to pay more than that price, it is often because there are new developments that make the company worth more. Stocks that are trading near their resistance point have the potential to show upside volatility as the market is showing expectations for new information.
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Chart 4 - Once the stock broke through the resistance point, it continued higher and showed a greater degree of volatility than it had in the past. This directional move combined with the added volatility is an excellent opportunity for the trader.
Stocks that come through with positive new developments are able to break through resistance and go into uptrends. Those that don't live up to the market's optimistic expectations often bounce off the ceiling price and remain in the trading range. Legitimate breakouts are often combined with an abnormal trading volume at the time of the breakout.
Summary
Understanding support and resistance is essential to becoming a successful technical investor. They act as visible thresholds indicating the state of market psychology. Breakouts and breakdowns are strong signals for directional moves that should not be ignored. Experience in visual assessment of charts and their levels of support and resistance will help determine exit and entry points for investors.
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