Support and Resistance
Find support and resistance on a chart
Support and resistance identify areas of supply and demand. But what exactly is supply and demand?
Supply is an area on a chart where sellers are likely going to overwhelm buyers causing the stock to go down. On a chart, we call this resistance.
Demand is an area on a chart where buyers are likely going to overwhelm sellers causing the stock to go up. On a chart, we call this support.
Knowing this, it only makes sense to buy at support and sell at resistance!
Stocks run into resistance (supply) because those traders that bought too late and saw the price go down now want to get out at break even so they sell. Stocks find support (demand) because those traders that missed the move up now have a second chance to get in so they buy.
The picture below shows support and resistance and the laws of supply and demand.
Support can become resistance and resistance can become support if prices break through these areas. Here is an example:
In the picture above you can see that once prices fell through support (1) it became resistance (2) and once prices broke through resistance (3) it became support (4).
Ok, you probably already knew all that but here is something that most traders do not know. There are varying degrees of support and resistance.
On the long side, when a stock falls down to a prior low it is more significant than when a stock falls down to a prior high.
On the short side, when a stock rises up to a prior high it is more significant that when a stocks rises up to a prior low.
In other words, the more times a support or resistance area is "hit", the more significant it is. In the first picture above, the support and resistance areas are very significant, whereas in the second picture these areas are only somewhat significant.
Enough rambling, let’s look at some charts...
The chart above shows how stocks run into resistance. But look at the areas that I highlighted in yellow. What are these traders doing buying stocks that are running up into an area of supply (resistance)?
Now, look at the chart below:
The chart above shows how stocks find support. But look at the areas that I highlighted in yellow. What are these traders doing selling stocks that are going down into an area of demand (support)?
They do that because they are novice traders. They always buy after significant buying has already taken place into areas of resistance, and they always sell after significant selling has already taken place into areas of support. YOUR JOB AS A SWING TRADER IS TO IDENTIFY THE NOVICE TRADERS BECAUSE THOSE TRADERS ARE THE ONES YOU WILL PROFIT FROM.
But wait! There are other forms of support and resistance that are not so common. For example, look for stocks that pull back and find support halfway into a prior wide range candle. Like this:
Or, look for stocks to pull back and find support halfway into a gap...
The bottom line is that you want to be buying stocks where buyers will likely come into the stock. You want to be selling stocks where sellers will likely come into the stock. Don't follow the novice traders!
Support and Resistance in an Uptrend
Although the motivation is not the same, many of the same forces that lead to technical downtrends are also at work in the creation of the technical uptrend. These patterns occur because investors chasing a strong stock rationalize that paying a higher than their intended purchase price is warranted given the strength of the issue. The higher the stock price moves, the more likely it is that investors will rationalize why paying a higher price makes sense -- to a point. Some will argue this rationalization process is directly related to a perceived change in fundamental factors and very often this is true. Understanding technical analysis does not mean that fundamental factors should be dismissed.
SLM Holding Corp. was one of the few issues to move significantly higher in the latter half of 2000. The stock emerged from a small base pattern in the middle of September at $45 and never really looked back. When this level was penetrated on better than average volume it became important technical support and buyers were more than willing to step-up and buy on every decline to that level. In early October SLM Holding tested support at $45 on three separate occasions. In each case the stock rallied briskly and after one such test in the middle of October SLM Holding began to trend so strongly that the stock nearly added 30-percent in just two weeks. That process lifted the stock to a new resistance point at $59. SLM Holding failed to push through the $59 level on two occasions but in early December volume surged and the share price easily moved beyond $59. Once again the result of the upside breakout was a significant near term rally. This time the stock rallied to $68.50 before sellers emerged. We have delineated the key support and resistance levels with green and red arrow respectively. These arrows reveal just how powerful is the role of support and resistance in the formation of a typical technical uptrend.
Support and Resistance in a Downtrend
The relationship between price and time is linear so investors that buy stocks "wrong" are first motivated to sell the position without suffering a loss but as days become weeks and weeks become months a rationalization process occurs that allows these same investors to sell their position for a loss. Of course they want to get the best price possible so they watch the price action very carefully, noting what price points lead to buying and what price points lead to selling. We understand that these price points are not random, they are support and resistance.
In the case of active sport and footwear maker Timberland Co. (TBL) support and resistance price points are obvious. After a lengthy run to new highs, Timberland fell out of favor in a weak retailing environment. In January of 2001 the stock made a new high above $72 but by February the share price was falling fast. In early February Timberland shares fell to $59.50 and rebounded to $66 just a few days later. This $59.50 level became the first major support level of the new downtrend. By late February the $59.50 support level had been smashed and a relative new low was made at $51.50. This time buyers "dug-in" and the stock rallied smartly only to find sellers at what had been the previous support level at $59.50. Of course, this level was now resistance. Through most of the next three weeks the stock meandered near the support level at $51.50 until that level was broken in early April. After falling as low as $42, Timberland shares made several attempts to rally back through the $51.50 resistance level but every attempt was rebuffed. As the series of green support and red resistance arrows reveal, this stair-step pattern created a very well-defined technical downtrend. Note how sellers become willing to sell their shares for successively less as time passes. This may occur due to a change in fundamental factors but the result is a stair-step pattern of support and resistance.
Support and Resistance in a Flat Base
In the real world of price dynamics levels that had proven to be resistance become excellent support once they are violated (and vice versa). This occurs because those who were merely trying to close the position without suffering a loss are systematically replaced with investors committed to that price. Often these new investors will be characterized as having "strong hands" but make no mistake, the characterization says little about their physical attributes. Their hands are strong because their commitment to the stock is new. Should the stock fail to perform as anticipated, their commitment will wane (and their hands become less strong).
Like so many technology stocks, Adobe Systems had a tumultuous fall from grace following a big rally into March of 2000. After finding a low in the middle of March 2001 the stock began the process of retracing some of the year-long losses. The stock rallied from the low at $25 in the middle of March to a high of $38 at the end of that same month before willing sellers emerged. On two separate occasions the stock rallied to this resistance level at $38 only to falter but in early April volume swelled and Adobe Systems gapped-up through the $38 level on impressive volume. This level now became support because willing sellers at $38 had been replaced with willing buyers. After "breaking out" from this consolidation pattern the stock immediately began trending higher, rallying to $48.50 before sellers emerged again. Through the remainder of April, May and June Adobe Systems was mired in a large and very clearly defined consolidation phase with support at $38 and resistance at $48.50. Resistance is labeled with red arrows and support is labeled in green.