Support and resistance levels act as a glimpse into the psychology of the traders who are active in a stock. Identifying them on a chart and determining their levels of significance is massively important. Here we discuss how to identify them, the psychology behind them, and how best to factor them into your trading and investment strategy.
How do you define support and resistance?
Support is where a share price tends to stop falling, and resistance is where the share price tends to stop rising.
These two levels represent supply and demand. Support represents demand by being a price point at which demand is strong enough to prevent the price from declining any further. Resistance represents supply by being a price point at which selling is strong enough to prevent the price from rising any further.
Expressed differently, support is an area on a chart where buyers are likely to overwhelm sellers, whereas resistance is an area where sellers are going to overwhelm buyers.
What does support and resistance look like on a chart?
Probably the best way to understand the concept is to see an example on a chart:
The chart above shows how when the share price reached a previous low at around 88 pence (support) it rebounded, but when reaching a previous high at around 109 pence (resistance) it fell. Perhaps most interesting about the chart above is that even after a sizeable shift in price to the up and then to the down, the historic level of support at around 88 pence per share appears to have acted as a buffer.
However, this isn’t the only pattern of behaviour when it comes to support and resistance. Sooner or later, support or resistance levels are broken. Once broken, they often become the opposite of what they were previously. In other words, the previous support level becomes the new point of resistance, and the previous level of resistance becomes the new area of support.
Why does happen? Well, a break in resistance, for example, signals that the forces of demand have overcome the forces of supply — buyers have increased their expectations and are now willing to buy at even higher prices, whilst sellers are less incentivised to sell believing they can achieve a better price for their holdings. Therefore, should the price later return to that previous level of resistance, there is likely to be an increase in demand, and hence support.
The following is an example of how the resistance became the new area of support:
Looking at the yellow box above, the area around 774 was tested on a number of occasions across several months but the share price kept failing to break through, instead returning to around 724. Once finally breaking through, the share price gradually declined across the next month but found support at the previous level of resistance before making another leg up to a high of 900 pence per share.
As well as this pattern, there are also other depictions of support and resistance that are less common but still something to look out for. For instance, often a stock will pull back and find support halfway inside a prior wide range candle. In addition, there is also the pattern whereby the stock pulls back and finds support halfway into a previous gap.
Generally, though, the greater the number of times the price tests a support or resistance area, the more significant the level becomes. The reason being, by bouncing off of the support or resistance level a growing number of times, an increasing number of buyers and sellers are going to base their trading decisions on those price points.
Moreover, the more apparent a point of support and resistance, the more anticipation for these to be broken. Such anticipation creates a buzz of activity when new highs or lows are finally reached, often resulting in a significant push above the previous high or a significant drop below that previous low.
What is the psychology behind levels of support and resistance?
Support and resistance levels are a valuable insight into human emotion when it comes to trading. The best way to demonstrate this is through a few examples using Investor Bob…
Example One: The share price of Company X all of a sudden shoots through a previous level of resistance following the release of positive news. After several up days, the price begins to fall again with individuals and institutions deciding to take profit. The price begins to approach its previous level of resistance and now all of those who were out of the stock before the price rise, including Investor Bob, come into the stock believing this to be a great entry point as the positive news still remains.
Example Two: Investor Bob purchases a company’s shares at 500 pence per share. The share price goes up to 600 pence per share but soon after falls back to 500 pence. Tom rues the missed opportunity of missing at 600 so when the price begins to approach the same price again he quickly sells and takes the profit.
Example Three: Investor Bob purchases a company’s shares at 150 pence per share and later sells at 200 pence per share. However, the share price of the company continues to climb up to 250 pence per share. Bob is frustrated that they sold so early and feels the company still represents a good investment. Based on this, he decides that he’ll re-establish a position in the company if the share price returns to 200 pence per share. As such, the demand for this stock is improved and established at a higher price point.
Example Four: Investor Bob has been monitoring a stock for an extended period of time and observed that it has a significant level of resistance at 400 pence per share. Having tested this area on a number of occasions, it finally breaks through this barrier and shows signs of reaching new highs. Seeing the potential of the company, Bob decides to finally pull the trigger and quickly invest now that the resistance has been broken.
There are many more scenarios like this but hopefully this depicts how market participants are often controlled by the same emotions and thought processes that end up creating these patterns of support and resistance.
What trading tips are there for using support and resistance?
Support and resistance levels provide valuable insight on potential entry and exit points. Ultimately, you want to look to buy at support and potentially consider selling at resistance. Yes, it is always possible that an area of support could be broken on that occasion, but if there are signs of consolidation then it would appear that the area is still being respected. In addition, through using stop losses, the trade can be closed at a small loss if it does eventually turn in the wrong direction.
In terms of where to put your stop loss, this should be a small percentage below the support but not too close so that a fakeout isn’t going to hit your stop loss before moving back again in the anticipated direction.
Another tip on factoring in support and resistance levels into your trading is to determine whether the approach was preceded by a steep advance or steep decline. The reason being, a steep advance or decline will often be met with more competition and halted than a more gradual approach.
Overall, though, the significance of the zone is what matters most. For example, how many times has the price tested a support or resistance area? In addition, how significant was the previous level of resistance if the price is now approaching it as a new area of potential support?
Taking one step back, is the stock currently trending up or down? How does this impact our judgement on the future price movement? For this we can use a number of tools, but one of the most important is the moving average.