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Understanding support and resistance levels

When you are analysing stocks, multiple variables come into play. One of the most important concepts to understand in stock trading is trend analysis. Once you can identify patterns being exhibited in the stock market, you will start to recognise the existence of support levels and resistance levels. Resistance levels are price levels that stocks struggle to rise above, while support levels are price levels that stocks tend to stay above.

When analysts speak about bullish markets and bearish markets, there is always give-and-take between buyers and sellers. Buyers are the ones demanding stocks while sellers are the ones supplying the stocks. As this dynamic interaction takes place, price levels are formed. The uppermost price that the financial instrument fails to break through is the resistance level and the support level is the base price at which the instrument holds steady.

Now, it must be remembered that it is entirely possible for the price of the financial instrument to move outside of this general ‘range’, but the trend is for the price to remain within the support and resistance levels. Many analysts have questioned why prices tend to stick within a range-bound level, and much of this has to do with the general psychology of the market. Many traders assign an intrinsic or extrinsic value to financial instruments and general market sentiment typically results in a mean price at the top end and the bottom end.

Traders tend to enter the trading arena when the price of a financial instrument reaches its support level and they tend to exit a position when the price of a financial instrument reaches its resistance level. Neither support nor resistance levels are cast in stone. And it is entirely possible for these price points to shift as expectations change. The fundamental reason why support levels hold is that traders will use this benchmark price to enter the market. In other words when the price of a security starts to drop towards its support level, buyers flood the market en masse.

When excess buyers enter the market demanding a financial instrument, demand for that instrument increases, and when demand increases the price holds steady and starts to rise. This is precisely the reason why support levels continue to hold. By the same token, when traders exit a financial instrument at its resistance level, the price of that instrument is prevented from rising beyond the resistance level. Since a mass of traders adheres to support and resistance levels, the range of prices tends to hold steady.

A rather interesting phenomenon tends to take place when support and resistance levels are breached. If the price of a financial instrument drops below a support level, that support level becomes the new resistance level and the price at which it drops to becomes the new support level. This is caused by a shift in supply and demand, resulting in what is known as a role reversal. You should bear in mind that role reversals only occur when major movements beyond support and resistance levels have taken place.

Understanding the relevance of round numbers

Many buy and sell decisions traders make are based on round numbers. In other words, traders will enter or exit a position at a certain price point which is typically a round number: 10, 20, 25, 30, 35, 40, 45, 50 etc. These are psychological levels at which traders will tend to respond. Trader X may decide to buy Google (GOOG) when the price reaches $600 per share, or Trader Y may decide to sell Google stock when the price reaches $625 per share.

In the above section I explained why support and resistance levels tend to hold true for the most part. Buyers tend to keep the price of a stock at its support level when they continue to buy at that level (preventing the stock from falling further in price), while sellers tend to keep the price of a security at its resistance level (preventing the stock from rising further in price). This behaviour is typically reinforced by the psychological effect of round numbers.

Why are support and resistance levels so important?

It all comes back to trends. Since nobody can predict with 100% certainty how the price of a stock is going to move at any given point in the future, trends are golden. You can make assumptions and predictions based on trends and trend reversals.

For instance, if you know that a certain security has a price beyond which it cannot rise (or, more accurately, has not risen beyond in the past), that is your ‘take profit’ point. In other words that is where you will sell. Likewise if you know that the price of the security does not drop below a key support level (based on past performance), that is the price where you will buy the security.

To be on the safe side, it is always advisable to place your trade slightly above the support level so that you can buy the stock before it reaches the support level. And conversely you always want to sell the stock before it reaches the resistance level. In this way you can use support and resistance levels to maximise your earnings when you trade financial instruments.

Brett Chatz

Published: 30 July 2015

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.

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