A stock’s price is always governed by its demand and supply. When demand exceeds supply, the stock’s price moves up; when supply exceeds demand, its price comes down. These market forces (demand and supply) determine the support and resistance levels of stocks and indices.
What is a support level?
It is normal for stocks to rise and fall depending on a host of factors. When the demand for a stock keeps building up whenever it falls to a certain price, then that price is considered as the support level of a stock. To better explain the concept, take a look at image below (click here for a larger image):
You will observe that whenever the stock’s price has fallen to 59 level, it has picked up once again from there and not fallen further. And this has happened repeatedly – three times in a period spanning six months. This indicates that at this price level the investors/traders are interested to buy into the stock and the sellers are not eager to sell their stock. The 59 level is therefore referred to as the support level, as it is supporting the stock and not letting it fall further. You will also observe that after repeatedly testing its support level, the stock has consolidated for a brief while and then moved up dramatically.
A support level is determined over a period of time – let’s say 6 months or more. There is no point determining a support level for a short-term period, because stocks react to a host of events/situations spread across a certain period, so determining a short-term support level can be misleading.
Understand, a support level is not fixed forever – it can be broken. It is an established practice amongst technical analysts to consider a support level broken if the stock’s price falls 10–15% below its support level and then finds it tough climbing back to its support price.
What is a resistance level?
When there is a good amount of demand for a stock, it keeps going up. But as it touches new highs, there comes a point when investors/traders consider the stock fully priced or overpriced and begin selling it out. When a stock’s price fails to pierce its previous highs and keeps reacting every time it touches them, then such a price level is called a resistance level. To better explain the concept, take a look at chart below (click here for a larger image):
You can see that whenever the stock’s price has gone up, it has repeatedly met with resistance at the 75 level, four times in a period spanning seven months. This indicates that every time the stock touches 75, investors/traders sell the stock and fresh buyers are not interested to pick it up at these high levels. You can see that after repeatedly meeting resistance at higher levels, the stock has reacted sharply.
Just like support level, resistance level is determined over a period of time, say 6 months or more – determining a short-term resistance level can be misleading. Again, a resistance level too is not fixed forever – it can be pierced. It is an established practice amongst technical analysts to consider a resistance level pierced if the stock’s price rises 10–15% above its resistance level and then either keeps going up to make new highs or refuses to come back to its original resistance level.
What happens when support and resistance levels are broken?
When a support level is broken, it yells out a sell signal. It means that the stock’s price has lost its backbone, and having broken its support level decisively it can go on to test new lows. When a support level is broken convincingly and decisively, technical analysts then peg it as the new resistance level.
When a resistance level is pierced, it is a buy signal. It signifies that the stock’s price has taken off, and having pierced its resistance level decisively it can go on to touch new highs. When a resistance level is broken convincingly and decisively, technical analysts then peg it as the new support level.
When a stock falls to its support level, it is an opportunity to buy the stock. When it decisively breaks its support level, you must sell it off. When a stock closes in on its resistance level, you must sell it. When it decisively pierces it, you must buy it.
When a stock hovers between its support and resistance levels, then you can either trade in it by watching any news/announcements made by the company, or you can apply volume indicators to find out if a consolidation is underway. During these times, you must also scour bulk deals of the stock to find out if any financial institution/private player is picking up or dumping the stock.
These were the basics of support and resistance levels and I hope that you have grasped how they work. They are very simple to work with and you can, even now without going through the entire topic, enter into trades by working with support and resistance levels.