Support and Resistance

Support and Resistance

Support and Resistance—In Simple Words

Support and resistance represent key junctures where supply and demand meet. In the financial markets, prices are driven by excesses of supply (down) and demand (up). Supply is synonymous with bearish, bears, and selling. Demand is synonymous with bullish, bulls, and buying. These terms are used interchangeably throughout this and other articles. As demand increases, prices advance, and as supply increases, prices decline. When supply and demand are equal, prices move sideways as bulls and bears slug it out to gain control.

What Is Support?

Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

Amazon.com, Inc. (AMZN) Support and Resistance example chart from StockCharts.com

Support does not always hold, however, and a break below support signals that the bears have won out over the bulls. A decline below support indicates a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.

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.

What Is Resistance?

Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. Logic dictates that, as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

Lilly Eli & Co. (LLY) Support and Resistance example chart from StockCharts.com

Resistance does not always hold; a break above resistance signals that the bulls have won out over the bears. A break above resistance shows a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.

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.

Methods to Establish Support and Resistance?

Support and resistance share enough common characteristics to effectively be mirror images of each other.

Highs and Lows

Support can be established with the previous reaction lows, while resistance can be established by using the previous reaction highs.

The above chart for Halliburton (HAL) shows a large trading range between Dec-99 and Mar-00. Support was established with the October low around 31. In December, the stock returned to support in the mid-thirties and formed a low around 33. Finally, in February, the stock again returned to the support scene and formed a low around 32 1/2.

After each bounce off support, the stock traded all the way up to resistance. Resistance was first established by the September support break at 42.5. After a support level is broken, it can turn into a resistance level. From the October lows, the stock advanced to the new support-turned-resistance level around 42.5. When the stock failed to advance past 42.5, the resistance level was confirmed. The stock subsequently traded up to 42.5 two more times after that and failed to surpass resistance both times.

Support Equals Resistance

Another principle of technical analysis stipulates that support can turn into resistance and vice versa. Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance.

The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply; if the price returns to this level, there is likely to be an increase in demand and support will be found.

NASDAQ ($NDX) Support and Resistance example chart from StockCharts.com

In this example of the NASDAQ 100 Index ($NDX), the stock broke resistance at 935 in May-97 and traded just above this resistance level for over a month. As the stock remained above resistance, 935 was established as a new support level. The stock subsequently rose to 1150, but then fell back to test support at 935. After the second test of support at 935, this level is well established.

PeopleSoft, Inc. (PSFT) Support and Resistance example chart from StockCharts.com

In the above example from PeopleSoft (PSFT), we can see that support can turn into resistance and then back into support. PeopleSoft found support at 18 from Oct-98 to Jan-99 (green oval), but broke below support in Mar-99 as the bears overpowered the bulls. When the stock rebounded (red oval), there was still overhead supply at 18 and resistance was met from Jun-99 to Oct-99.

Where does this overhead supply come from? Demand was obviously increasing around 18 from Oct-98 to Mar-99 (green oval). Therefore, there were a lot of bullish buyers of the stock around 18. When the price declined below 18 and fell to around 14, many of these (now unhappy) bulls were probably still holding the stock. This left a supply overhang (commonly known as resistance) around 18. When the stock rebounded to 18, many of the green-oval-bulls probably took the opportunity to sell and “escape” with little to no loss. When this supply was exhausted, the demand was able to overpower supply and advance above resistance at 18.

Trading Range

Trading ranges can play an important role in determining whether support and resistance function as turning points or continuation patterns. A trading range is a period of time when prices move within a relatively tight range. This signals that the forces of supply and demand are evenly balanced. When the price breaks out of the trading range, above or below, it signals that a winner has emerged. A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply).

WorldCom Group (WCOEQ) Support and Resistance example chart from StockCharts.com

After an extended advance from 27 to 64, WorldCom (WCOM) entered into a trading range between 55 and 63 for about 5 months. There was a false breakout in mid-June when the stock briefly poked its head above 62 (red oval). This did not last long and a gap down a few days later nullified the breakout (black arrow). The stock then proceeded to break support at 55 in Aug-99 and trade as low as 50. Here is another example of support turning to resistance, as the stock bounced off 55 two more times before heading lower. While this does not always happen, a return to the new resistance level offers a second chance for longs to get out and shorts to enter the fray.

Lucent Technologies, Inc. (LU) Support and Resistance example chart from StockCharts.com

In Nov/Dec-99, Lucent Technologies (LU) formed a trading range that resembled a head and shoulders pattern (red oval). When the stock broke support at 60, there was little or no time to exit. Even though there is a long black candlestick indicating an open at 59, the stock fell so fast that it was impossible to exit above 44. In hindsight, the support line could have been drawn as an upward sloping neckline (blue line), and the support break would have come at 61. This is only 1 point higher and a trader would have had to take action immediately to avoid a sharp fall. However, the lows match up rather nicely on the neckline, and it is something to consider when drawing support lines.

After Lucent declined, a trading range was established between 40.5 and 47.5 for almost two months (green oval). The resistance level of the trading range was well marked by three reaction peaks at 47.5. The support level was not as clearly marked, but appeared to be between 40 and 41. Some buying interest began to become evident around 44 in mid- to late-February. Notice the array of candlesticks with long lower shadows, or hammers, as they are known. The stock then proceeded to form two up gaps on 24-Feb and 25-Feb, and finally closed above resistance at 48. This was a clear indication of demand winning out over supply. There were still two more opportunities (days) to get in on the action. On the third day after the breakout, the stock gapped up and moved above 56.

What Are Support and Resistance Zones?

Because technical analysis is not an exact science, it is useful to create support and resistance zones. This contradicts the strategy mapped out for Lucent Technologies (LU), but it is sometimes the case. Each security has its characteristics, and analysis should reflect the intricacies of the security. Sometimes, exact support and resistance levels are best, and sometimes, zones work better. Generally, the tighter the range, the more exact the level. If the trading range spans less than two months and the price range is relatively tight, then more exact support and resistance levels are best suited. If a trading range spans many months and the price range is relatively large, it is best to use support and resistance zones. These are only general guidelines, and each trading range should be judged on its own merits.

Returning to the analysis of Halliburton (HAL), we can see that the November high of the trading range (32 to 44) extended more than 20% past the October low, making the range quite large relative to the price. Because the September support break forms our first resistance level, we are ready to set up a resistance zone after the November high is formed, probably around early December. However, we are still unsure if a large trading range will develop. The subsequent low in December, which was just higher than the October low, offers evidence that a trading range is forming, and we are ready to set the support zone. As long as the stock trades within the boundaries set by the support and resistance zone, we will consider the trading range to be valid. Support may be looked upon as an opportunity to buy, and resistance as an opportunity to sell.

The Bottom Line

Identification of key support and resistance levels is an essential ingredient to successful technical analysis. Even though it's sometimes difficult to establish exact support and resistance levels, knowing their existence and location can greatly enhance analysis and forecasting abilities. If a security is approaching an important support level, it can serve as an alert to be extra vigilant in looking for signs of increased buying pressure and a potential reversal. If a security approaches a resistance level, it can act as an alert to signs of increased selling pressure and potential reversal. If a support or resistance level is broken, the relationship between supply and demand has changed. A resistance breakout signals that the bulls (demand) have gained the upper hand, and a support break signals that the bears (supply) have won the battle.

Support and Resistance Level FAQs

Why is the identification of support and resistance levels important in technical analysis?

Identifying key support and resistance levels helps in forecasting and analysis. The levels act as alerts for potential reversals and signify changes in the relationship between supply and demand.

In the financial markets, prices are driven by excesses of supply (which pushes prices down) and demand (which pushes prices up). When supply and demand are equal, prices move sideways. Support is the level where demand is strong enough to prevent the price from declining further, while resistance is where selling is strong enough to stop the price from rising further.

What does it mean when support turns into resistance and vice versa?

When a price breaks below a support level, the broken support can become a resistance level. Likewise, when the price rises above a resistance level, it can become a new support. This shift indicates changes in supply and demand dynamics.

What do support and resistance level breaks signify?

A break below support indicates sellers are willing to sell at even lower prices. It also indicates a lack of buyers. Conversely, a break above resistance shows a new willingness to buy at higher prices, and there's a lack of sellers.

A trading range is when prices move within a narrow range, signaling balanced supply and demand. A break above or below this range indicates that either the bulls (for an upward break) or bears (for a downward break) have taken control.