The Basics Of Support And Resistance
Frank Kollar | Dec 16, 2012 01:58AM ET
When it comes to trading the financial markets, support and resistance levels are the basis of almost all technical analysis charting patterns.
In the simplest terms, support and resistance levels are where the forces of supply and demand meet. They can be extremely obvious on some financial charts, or hard to spot without many years of experience on others.
Support and resistance levels are found in financial charts, from stocks, commodities, indexes, options, interest rates, even ETF and mutual fund charts. They are powerful trading tools when used correctly and with risk management.
When the price of a stock, or stock market index, moves lower, it is because more traders are selling than buying. This tells us that supply is increasing but demand is not. Selling is seen as bearish.
When the price of a stock or stock market index moves higher, it is because more traders are buying than selling. Supply is decreasing while demand is increasing. Buying is seen as bullish.
For this report we will look at individual stocks.
Support
When a stock reaches a point at which there are no more sellers, and the balance tips to buyers, prices begin to rise. This creates a support level that technical analysts will watch in the future as it may offer clues to future market moves. Not all levels created by reversals in price wind up being tested again. However those that do may react to the resistance or support level.
The best way to visualize a support level is with a chart. Below is a weekly chart of AmerisourceBergen (ABC). You can easily see the bottom when the 2008 bear market lows were reached in November of 2008.
But then in March of 2009, after a substantial rally off the November lows the stock ended at about $19.00 a share, AmerisourceBergen had again declined to that prior bear market low. This time when it reached the low the stock immediately reversed. The sellers evaporated and buyers jumped in. Why? Because the stock had reached an obvious support level and then showed that there were no more sellers to push prices lower.
Buyers jumped in to the market and the stock price reversed midweek and zoomed higher. That $14.00 level acted as powerful support when sellers could not push this stock lower. When sellers gave up, there were only buyers left and the stock soared.
Traders watching this chart had a huge advantage as they could buy AmerisourceBergen and place a sell stop just below the strong support level thus minimizing risk.
Get The News You Want
Notice how the advance stalled for several months (June-July) when the $19.00 level was reached in June. This was where the stock originally reversed from resistance (in January) and traders began to sell as the level was reached. But then AmerisourceBergen broke out above resistance (the January highs) and you can see how quickly sellers evaporated and buyers reentered the market and powered this stock higher. Again, it was all about support and resistance.
Resistance
The reverse of support occurs when a stock reaches a point at which there are no more buyers, and the balance tips to sellers, prices begin to fall. This creates a resistance level that technical analysts will watch in the future as it may offer clues to future market moves. Not all levels created by reversals in price wind up being tested again. However those that do may react to the resistance or support level.
Below is a daily chart of Unysis Corp (UIS) showing the last year of trading. After the bear market ended, Unysis entered an advance that remained strong until the beginning of 2010. At that point, around $40.00 a share, buyers decreased and sellers began to dominate the trading for Unysis, eventually pushing prices to a low around $28.00 a share in early February 2010. This created a strong resistance level at the $40.00 level
Sellers dominated and pushed prices down to about $28.00 a share where selling stopped and buyers again stepped in. The reversal to the upside, occurring at $28.00 a share in early February, created a new support level.
At this point the sellers pulled back and buyers stepped in, pushing prices back towards the previous high at $40.00. In mid-March the $40.00 level was again reached and prices reversed. Resistance at $40.00 a share was strong enough to again push prices lower. No matter the reason, whether it was fundamentals, a news event or a reversal in the general stock market, it makes no difference. $40.00 is now a strong and tested resistance level.
As a trader, a short position could have been entered after prices began to reverse the second time in mid-March, using the $40.00 resistance level as a buy stop to reduce risk.
If prices continue to decline for Unysis, they will eventually again reach $28.00. Should they reverse to the upside we will have a new support level. Should they break through the $28.00 level and move lower, that would point to lower lows ahead as support has been broken.
Again a trade could be taken using support at $28.00 for a bullish trade (after the stock reverses to the upside) and using $28.00 as a sell stop to control risk. If support at $28.00 was broken to the downside, a short trade could be taken using $28.00 as a buy stop to control risk.
Should prices rally from here and eventually push above the $40.00 level, it would be a breakout for Unysis. A low risk trade could be entered using the old resistance level at $40.00 a share as a sell stop thus creating a low risk bullish trade.
Conclusion
As you can see from the above charts, support or resistance can be used in many ways to set up trades. And this is just using the very basics of support and resistance. There are many trading tools based on support and resistance that can help pinpoint trades.
Support or resistance levels can also reverse. A support level (example $28.00 in the Unysis chart above) would become resistance if prices continued lower in the future and eventually broke below $28.00. The same applies in the reverse. If resistance is broken, say the $40.00 level is surpassed in the future, that level then becomes support.
Most technical analysis tools use support and resistance in some form. Many traders use support and resistance exclusively in their trading.
The above may seem confusing at first if you are new to looking at chart patterns. If you are used to doing so the above is old hat and you see these patterns without even thinking about it. Eventually it becomes second nature.
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