Education

Lesson 8: Support and Resistance

In our previous lesson we discussed types of charts. Today we will continue to learn about technical analysis and how its insights are useful to investors. The topics of the day are support and resistance: what they are, how they are established and what they mean for your trading strategy. We will talk about support and resistance levels, support and resistance zones, bearish and bullish movements, trading ranges, and their interpretation within the context of your trading activities.

There is much to be learned and not a minute to spare, so let’s hop to it!

Supply, demand and pricing

In financial markets, prices are determined by the forces of supply and demand.

While an excessive amount of supply will result in a fall in price, the opposite case (an excess of demand) will result in a hike in price.

Downward price movements are the result of an excess in supply and are associated with terms related to sales and bears. Upward price movements, however, are related to an excess in demand, and designated by words related to purchases and bulls. Sideway price movements where prices remain more or less stable emerge when market forces are balanced.

Support and resistance levels: what are they and what do they mean?

Support and resistance are price levels that describe a pattern in maximum highs and minimum lows over a certain period of time.

Support is determined by the lowest price levels in the period whereas resistance is determined by the highest higher peaks in that same period.

When prices movements occur within a tight radius, a trading range is born and support and resistance levels act as the top and bottom borders of the trading range.

Support and resistance levels are determined by the forces of supply and demand (bearish and bullish movements), and represent the turning points in price variation. Think of support and resistance levels as “bouncing points” or “buffers” from which prices within a trading range usually bounce back when reached.

So what is support, exactly?

Based on the theory that price movements tend to stop and reverse at certain price levels, support is the level at which prices reach their lowest point before heading in the other direction. Support is determined by the forces of the market and established based on a pattern in the historic lows of a certain period.

An example of a support level is shown in the chart below (red line):

The theory of support is based on the assumption that, as prices get cheaper and approach the support level, sellers are less likely to sell whereas buyers are more likely to buy. In this sense, demand is expected to overpower supply at the support level and thus prevent prices to continue to fall.

This being said, support and resistance levels are not written in stone and prices breaking support levels is not unheard of.

What happens when a support level is broken?

Prices fall below the support level in two scenarios:

1. when sellers are more willing to sell and are thus offer their securities at a cheaper price
2. when buyers are less interested in buying and the only way to make a sale is by lowering the price.

A support level is broken when prices fall below support level. When this occurs, a new support level needs to be established.

A security approaching support is a call for alertness and investors should look for signs of heightened purchase pressure or, alternatively, possible reversal.

What is resistance?

Resistance is the counterpart of support. Resistance levels are defined by the price at which supply is abundant enough to prevent the price from growing further. Resistance theory believes that the closer the price comes to resistance, the more likely sellers will sell whereas buyers are more unlikely to buy. This way, supply overcomes demand and prevents prices from growing further.

Here is an example of what a resistance line looks like:

What happens when a resistance level is broken?

A break in resistance happens when buyers become more willing to buy or when sellers become less open to selling (aka demand overcomes supply). In these situations, sellers are unlikely to sell unless

1. prices rise above resistance
2. prices rise above the market’s latest peak.

As with support, once a resistance level is broken, a new resistance will be established at a higher level.

When a security approaches resistance, a good investor should look for signs of increased pressure on supply and possible market reversal.

How are support and resistance levels established?

There are two ways to determine support and resistance levels: highs and lows, and support equals resistance. Let’s have a closer look at each of them.

The Highs and Lows Method

Support and resistance are established based on previous reaction lows and highs. A reaction is a change in direction in price movement.The following graph shows an example of reaction highs and lows.

Support and resistance levels serve as a buffer to price movements. After each bounce, price levels will reach these buffer zones, move in the opposite direction and continue until reaching the counterpart buffer.

The Support Equals Resistance Method

The principle of this method is based on the belief that support and resistance levels can mute into their counterparts. This means that resistance may become support when prices rise above resistance. This happens when demand overcomes supply.

Furthermore, the support level of one period of time is likely to become the resistance level the next period. This is true when prices fall below support, signaling that supply is stronger than demand. The following is an example of such transformations:

In the chart above, the support level was broken. Prices reached a new low and eventually bounced of what would become the new support level, and previous support was left to play the role of resistance.

The next chart depicts one more scenario, where a fall in price turned the then current support into resistance and, after some time, the resistance level turned into the support level again:

Trading Range

Trading ranges appear as prices bounce within a relatively tight range over a period of time. Trading ranges show that the market is balanced and that neither supply nor demand have won the upper hand. Contrary to this, a break in support or resistance would show a market inbalance: a break in resistance would indicate a win for the bulls (excess demand) whereas a break in support shows a win for the bears (excess supply).

To illustrate this, let’s have a look at the following graph where a trading range was established between 375.00 support and 420.00 resistance.

Sometimes you can see how the price peaks are disregarded as a break in the resistance or support levels. Such decisions are made when outbreaks are quickly compensated by prices moving in the other direction and back into the original trading range.

The previous graph is a good example of how one period’s support can become another period’s resistance after a fall in price.

A similar situation can be seen in the following chart:

In the previous chart we also see a return to the new resistance. Although such cases are not very frequent, they are a great opportunity for long term investors to exit and newcomers to enter.

Support and Resistance Zones

Although linear support and resistance levels can be useful in some cases, in others in might come in less handy.

For these occasions, support and resistance zones are preferred. An example for such an instance would be when dealing with loose trading ranges over long periods of time. The looser the range, the less precise support and resistance becomes. On the other hand, linear support and resistance levels are much more appropriate when dealing with trading ranges that are tight and short term.

An example can by revisiting the chart we saw in the highs and lows theory:

Support and resistance zones can indicate the best opportunities to buy (support) and to sell (resistance) opportunity to buy, and resistance as an opportunity to sell.

Conclusion

Let’s put it all together. Why are support and resistance levels important?

Support and resistance levels can indicate the best opportunities to buy (for support levels) or to sell (for resistance levels).

For example, in our trade recommendation we sometimes say “watch for reversal signals at the X level”. This is because that level was identified as a support or resistance level. By watching the price action there we can determine:

• In case of the support: Did the market fall through (the support failed?) or did it bounce back (there was a reversal indication). If it bounced back, then that is an opportunity to buy. If it fails, it is an opportunity to either sell, or do nothing.
• In case of a resistance level. If the market reaches a level which was identified as a resistance level, then we need to watch the price action again. If it breaks the resistance level and continues upwards, it’s a sign to either stay in the trade or buy again. If it is unable to break the resistance, we should be ready to sell, as it can bounce back down.

In the next lesson, we will talk about Trend Lines.