Identifying and analysing trends in stock prices are two key functions of trading. Investors and traders can determine whether underlying market conditions are favouring their positions or not and how long will that hold by analysing trends. This way, they recognise entry and exit points; support and resistance are two essential concepts in that regard.
Analysts derive support and resistance levels by tracing patterns of price movements, which, in turn, act as barriers to stock price actions. However, these levels are temporary and change as stock prices violate these barriers.
Support line refers to that level below which a stock’s or asset’s price cannot travel. Often, either the price tends to move toward the support line and flatten upon reaching it or bounce back up.
Just on the flip side of this same coin lays the resistance line – the price level above which a stock cannot rally. Prices either plateau or move downward upon hitting this barrier.
Analysts identify these lines based on trends where a particular asset has failed to violate a price point repeatedly over time. Although there’s no specific support and resistance formula, traders apply indicators like moving averages and tools like Fibonacci Retracement to determine the levels.
Imagine a stock X, which has rallied to the price point of Rs. 75, five times over 6 months, only to run out of gas every time it reaches that.
Thus, one can identify Rs. 75 as the resistance line or the ceiling price of that stock for the time being. Conversely, if stock X downtrends six times during that period only to bounce back up after reaching Rs. 40, that’s the support line.
Identifying support and resistance level is critical in determining entry and exit points of particular assets.
It’s essential to note on the get-go that support and resistance are arbitrary levels derived based on price trends, which are inherently linked with investor sentiments. On the other hand, support and resistance lines influence investor sentiments, prompting them to sell or buy, as the case may be.
Traders buy new units of a stock when its price is approaching that level or reaching it. This decision is prompted by the belief that the support level will not be violated and prices will eventually move upwards.
Interestingly, when numerous traders buy stocks at or around the support level, the prices immediately start moving north due to a spike in demand. Hence, support level sustains itself over time by influencing and being influenced by investor sentiments, unless some unusual development pushes the price below that line.
The resistance line acts as an exit point for traders. That’s because they believe that an asset’s price will fall upon touching or immediately prior to reaching the resistance line following an upward trend.
Ergo, the resistance level prompts traders to sell lest they face losses. And as traders sell assets in large numbers, prices move downward. Here also, the resistance line sustains itself.
However, support and resistance lines don’t stay static over a prolonged period but rather form an upward or downward slope. Thus, most experienced traders apply trendlines to derive these price levels.
By determining the broader area of support or resistance based on trendlines, traders can anticipate future price actions better over a sustained period.
For instance, a series of historically northward moving lows help form an upward slope that demonstrates a region below which price struggles to move.
Traders consider four vital factors to determine the reliability of support and resistance lines. These are –
Analysts often identify significant price points, and, in turn, support and resistance levels, by taking into account the volume of trading. A price point that clocks substantial selling or buying can be deemed reliable.
For instance, if trends show that particular price action has caused investors to sell a specific class of assets or stock in considerable volume, investors will likely assume a short position when it reaches that level next.
It speaks to the general psychology of investors to sell at the breakeven point rather than prior to it because of the expectation of a continuing upward trend.
The number of times a price level has touched a support or resistance line only to rebound also determines its reliability. For instance, a support line that continuously prevents the price from falling below it is more dependable and, thus, more traders will base their buying decisions on it. On the other hand, a level that does not hold to price actions consistently is less significant to traders.
Adding to the above-pointer, a support or resistance level becomes more reliable the longer it can hold to price actions. In this understanding, the number of times prices have reached that certain level is also crucial.
Generally, if a support or resistance level follows a steep rise or decline in price, it’s more significant. That’s because such a price movement attracts investors’ attention more than a slow-moving upward or downward trend. Hence, it is likely to be met with a heftier resistance or more robust support.
Traders also take into account instances – and events leading up to that – where price action has violated a support or resistance line to predict their future occurrences better. Often, a previous support line can become a resistance line, demonstrating a significant fall in prices. Conversely, a resistance line can turn into a support line as well if prices shoot up considerably.