How Can Resistance & Support Help Traders ?

People who look at technical analysis to trade stocks, should always know the concepts of resistance and support levels. They are undoubtedly two of the most highly discussed attributes of technical analysis. They seem complex to begin with, but they actually are not. Lets look at these levels in depth to get a better understanding of them.

Traders use resistance and support levels to refer to price levels on charts that tend to act as barriers from preventing the price of the stock from getting pushed in a certain direction.

Basics of Resistance & Support Level
Most experienced traders who closely follow the price pattern of the stocks know how at a certain price level, the price of the stock doesnt move upward or downward much furthur. Let us look at an example to understand this pattern. Say in March 2006, a company Steady Inc. was priced at $37/stock. For the next several months Steady Inc’s stock price fails to get above $39/stock. Even though it has gotten very close to moving about $39, it still doesn’t move upward. In this case, the price level of $39 is called the level of resistance. Resistance levels are regarded as price levels that prevent the stock price from moving upward.

On the other hand, support levels are the exact opposite of resistance levels. Say for the next several months Steady Inc’s price always holds above $26/stock. Even though Steady Inc reported disappointing earnings, the stock price did not fall below $26. In this case, the price level of $26 is called the level of support. Support levels are regarded as price levels that prevent the stock price from moving downward. Another example below shows how the stock price failed to go below $51.25, forming a level of support.

So what does resistance level and support level tell traders ? How do traders react to these levels ?
Traders look at these levels as trading opportunity. When the stock reaches the support level, most traders believe it is a good buying opportunity. With more buyers in the market, the stock prices push higher again. Similarly when the stock reaches the resistance level, most traders believe it is a good shorting opportunity. Traders holding the stock believe it is good time to sell off and take the profit, eventually pushing the prices lower.

However over a period of time, there is a possibility that the stock prices may break these price barriers and trend upward or downward. This behaviour is not uncommon. Generally when the resistance level is broken, the prices trend to move fairly upward before forming a new resistance level. Similar is true when the support level is broken.

The support & resistance levels get stronger and stronger depending on how many times the stock price has historically been unable to move beyond it. Many technical traders will use these strong support and resistance levels to choose strategic entry/exit prices, making it more difficult to drive the price upward or downward. Additionally since the traders are more confident at these levels, the volume of trading generally increases ensuring difficulty in furthur driving the prices higher or lower.

Unique Characteristic of Resistance/Support Levels
Another common characteristic of resistance/support is that a stock price may have a difficult time moving beyond a round price level such as $10. Most inexperienced traders tend to buy/sell stocks 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 $10.04. 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, $15, it would take an extreme number of purchases to absorb these sales and, therefore, a level of resistance would be created.

Moving Averages + Resistance/Short Level = Short-term Price Patterns
Many technical traders use moving average to help them predict future short-term price patterns. However these traders never fully realize the ability of moving average for identifying levels of support and resistance. 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 stock finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down.

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.

(Source: Investopedia)