Support and Resistance
After introducing the concept of trend and talking about the different types of trends, we will now turn our attention towards two of the most commonly used words in technical parlance: support and resistance. Even an individual who is not well versed with Technical Analysis will have heard about these two words given how frequently they appear in financial newspapers, media, etc. So, what exactly does one mean by support and resistance?
Well, in the earlier section, we talked about the three different trends: up, down, and sideways. We defined as uptrend as a sequence of rising peaks and troughs wherein each peak is above its previous peak and each trough is above its previous trough. In this sequence, each rising peak is called an area of resistance while each rising trough is called an area of support
As the name suggests, resistance is something which stops the price from rising further. The resistance level is a price point on the chart where traders expect maximum supply (in terms of selling) for the stock/index. The resistance level is always above the current market price.
The likelihood of the price rising to the resistance level, consolidating, absorbing all the supply, and declining is high. The resistance is one of the critical technical analysis tools which market participants look at in a rising market. The resistance often acts as a trigger to sell.
Where Is Resistance Established?
Resistance levels are usually above the current price, but it is not uncommon for a security to trade at or near resistance. In addition, price movements can be volatile and rise above resistance briefly. Sometimes it does not seem logical to consider a resistance level broken if the price closes 1/8 above the established resistance level. For this reason, some traders and investors establish resistance zones.
A support can be defined as a region where the forces of demand exceed the forces of supply, causing the price of an asset to turn higher. Often, an area of support can be identified by looking at the past price action on a chart. It is usually the region where buying (demand) exceeded selling (supply), causing price to turn from down to up. Simply put, support is the lowest point reached before price reversed to the upside.
Where Is Support Established?
Support levels are usually below the current price, but it is not uncommon for a security to trade at or near support. As technical analysis is not an exact science, setting precise support levels can often be difficult. In addition, price movements can be volatile and briefly dip below support. For example, it does not seem logical to consider a support level broken if the price closes an eighth below the established support level. For this reason, some traders and investors establish support zones.
Importance of support and resistance in an uptrend
In an uptrend, one would expect each high to go above its previous resistance and each low to be above its previous support. As long as this sequence of higher highs and lows continues, an uptrend is said to be intact and an individual who is long the asset can continue holding on to it or add more positions if necessary. However, in an uptrend, if after a sequence of higher highs and lows, the next high does not break above the previous resistance, it is an early warning that the uptrend could be weakening. If on the ensuing decline, the price breaks below the previous support, it is an indication of a reversal in trend. Such an event alerts an individual to cut down on his bullish bets on the asset and depending on his style of trading, open fresh short positions. The chart below illustrates why it is important to keep monitoring areas of support and resistance in an uptrend. There is also a concept called ‘change of polarity principle’, which states that a support once broken become a potential resistance on the ensuing rally.
Importance of support and resistance in a downtrend
The role of support and resistance gets reversed in a downtrend. In a downtrend, each low breaks below its previous support and each high fails to exceed the previous resistance. As long as this sequence of lower lows and highs persists, a downtrend is said to be intact. However, in a downtrend, if after a sequence of lower lows and highs, the next low does not break below the previous support, it is an early warning that the downtrend could be weakening. If on the ensuing rally, the price breaks above the previous resistance, it is an indication of a reversal in trend. Such an event suggests that a new uptrend has begun and warrants establishing bullish bets in an asset. The chart below illustrates why it is important to keep monitoring areas of support and resistance in a downtrend. Confirmation of an uptrend occurs when on the ensuing decline price holds at or above the previous resistance which has now turned into a support (change of polarity principle).