In trading, analyzing the market conditions is vital for investors and traders to find their entry and exit points. Only by identifying and studying trends in the stock price can they determine whether market conditions are favorable for them, how long the current trend will last, etc. Understanding these conditions with the right tools will help traders and investors safely enter and exit the market.
What are Support and Resistance?
Support and Resistance are two major tools for analyzing the stock market trends. By analyzing price patterns, traders and investors will be able to modify their entry and exit strategies by deriving support and resistance levels.
Analysts identify these by analyzing the price trends of a particular asset. They identify the pattern in failing to cross a certain price level repeatedly over a period as it ascends and descends across the chart.
There is no specific formula to identify the support line or resistance line. Traders commonly use indicators like the moving averages or tools like the Fibonacci Retracement to derive the levels.
Support Line
Support line is the assumed level below which a stock price cannot fall on a stock price chart. This means that when a stock price goes down, it tends not to travel beyond the support level. Once it reaches the support level, it will either flatten or bounce back up.
For example, imagine a stock A, which has fallen to $50 around 5 times in a year. But once reaching $50, the stock price always rises back or moves on a flat line. Upon analyzing the pattern, analysts consider this price to be its support line.
Resistance Line
The resistance line is the flip side of the support line. That is, the stock price, when rallying up, will run out of gas once it reaches the resistance level. The stock price will either plateau up on hitting the resistance level, or will fall back.
For example, the stock A, which has reached up to $500 around 6 times in a year, fails to move up every time. Reaching the price, it either flattens or drops down. When analysts examine this trend, the $500 will be considered its resistance line.
How do Support and Resistance Work?
The supply and demand of an asset are the fundamental economic forces that create support and resistance levels. When demand exceeds supply, the support level is formed. Whereas, when the supply exceeds demand, it creates a resistance level.
The support level is also called the ‘floor price’. At a ‘floor’, a falling stock price stops and reverses as the buying interest will be strong. While the resistance level is called a ‘ceiling price,’ upon hitting which a stock price stops rising and starts to fall because the selling interest will be high.
Identifying Tools :
- Swing highs/ swing lows: These are the peaks or valleys that appear on a stock chart by connecting the dots on the horizontal line.
- Trendlines: These are the diagonal support or resistance. The floor/ ceiling price doesn’t always stay flat. A floor/ceiling could be constantly rising/ falling.
- Moving Average(MA): This is the average price point based on the dynamic support and resistance. While this moves with the price, unlike a static line, an MA of a period of time could act as a support in a bull market.
- Volume: It is the total number of shares/securities traded within a timeframe. This validates the support/ resistance lines. A high volume indicates the strength of the levels.
Are Support and Resistance Lines Reliable?
One of the most important things to note is that the support and resistance levels are entirely arbitrary. These temporary levels are derived as per the price trends and can influence or be influenced by the investors’ sentiments.
The market mechanics often violate the support/ resistance levels on various occasions. Which include:
- The Breakout: When the stock price moves beyond a support/ resistance level, which it struggled to cross previously.
- The Retest (Role Reversal): Sometimes a support level can break, forming the new resistance level or vice versa.
- False Breakout (Fakeout): This is a false breaking of a support/ resistance level. When this happens, the stock price breaks the level and moves forward momentarily, only to return to its previous position.
The support/ resistance levels don’t stay static for a long period of time, and the trading volume and investor sentiment can always influence their movement. That’s why experienced traders depend on the trendlines while entering the market.
The Risk Management
There are many ways in which traders resist potential losses in a downward trend.
- Stop-Loss Order: The traders can place a sell order just below the support line. So, if the floor breaks, the trader can safely exit without much loss.
- Target Price: Setting a benchmark within a timeframe, usually at the next resistance level, to exist with a profit.
The above article on the support and resistance levels and the commentaries based on their technical analysis are for educational and informational purposes only. They do not serve as financial advice under any circumstances.
