The concept of support and resistance is extremely interesting, and one which will help you considerably in the timing of your trading decisions. Yet it is a very simple concept to grasp. Support and resistance are basic tools used by traders to identify key reversal areas. As the names suggest support acts to keep the price above a certain level, whilst resistance acts to keep a share’s price below a certain level. Drawing support and resistance lines on charts, allows us not only to determine where these levels are, but also to consider future price movement in relation to them. Oh and don’t worry, all charting packages have the facility to draw lines on the screen.
Firstly, let me try to explain how and why these levels arise. Imagine a price is moving up and then subsequently starts moving down again. At the turning point there will be many buyers trapped who did not sell before prices moved down, and have decided to wait until the price moves back up again before selling ( they are living in hope ! ) Let us assume now that the price has stopped falling, and has started rising again. As it nears the point at which it turned the first time, those trapped buyers breath a sigh of relief and sell at breakeven or slightly less, which forces the price back down again as there is now more selling pressure than buying pressure. Naturally in the up move there has been buying, and these buyers now become trapped as prices move back down again. Now this can be repeated many times over, and you will see many different instruments including shares that behave in this way. In some cases this price action can last days, weeks or even months.
At the point where prices were falling and then started rising, exactly the same thing is occurring, but in reverse of course. We now have short sellers who are trapped at the bottom and have to wait for the price to come back down to them, who gratefully close their positions when this happens, to be replaced by more short sellers who are then trapped in turn….. – I think you get the picture.!
When this price action happens, it has several consequences. Firstly it produces what we call a channel and the instrument is said to be channeling ( or range trading ). The prices form a defined channel with two lines that can be drawn, one above, and one below. Now the important part for us is not to practice our drawing skills, but these lines actually help us considerably. Once one of these lines is penetrated by prices, it becomes a line of support ( for prices going up ) and a line of resistance for prices going down.
Let’s imagine we have been watching a share for some months which has been trading within a channel. Suddenly we notice one day that it has broken above the line and prices are now moving up. The line that was originally resistance to higher prices has now become a line of support and we can trade with more confidence, knowing that if the prices are going to go back down again they will have to penetrate this line of support or floor if you like. If you imagine a building with two floors, prices have moved from the ground floor through to the first floor, and what was the ceiling, has now become the floor. In other words it has become a SUPPORT to higher prices and will take effort to penetrate if prices fall back. It gives us a little more comfort ( but not too much ) in now buying into the move.
Using the house analogy again, we can see what happens at the bottom of the channel. Suppose we notice one day that prices have gone through the ground floor and into the basement, what was the floor has now become the ceiling and has become RESISTANCE to prices going back up to ground floor level.
Now, one final point on support and resistance. This occurs when prices gap up’ or gap down’. This occurs when the opening price the following day, has opened at a different price from that which it closed at the night before. Now the reason I mention it in the context of support and resistance is simply this – if prices break out of a channel with a gap up ( going up ) or a gap down ( going down ) this adds weight to the move and weight to your decision to trade. The reason the gap has formed is because the market makers have opened prices with a significant gap ( up or down ) – they have done this for a reason. If it also coincides with a break out from a channel you can be reasonably sure that this confirms the move and therefore has more significance. Look out for them, they are worth the wait!