The following was saved from the old investorzblog.com website. Just in case anyone was looking for it (with the help of archive.org).
Support and Resistance: Technical Analysis
A commonly used investment method is technical analysis. The basics of technical analysis lie in support and resistance. In this post, I will teach you the basics of support and resistance. But remember, just reading this post isn’t enough. You have to practice it! Remember that all technical analysis is based on the psychology of players in the market. So not only will I be explaining what Support and Resistance are, but I will also explain why this works, and what’s the market psychology behind it.
Let me begin by saying that support and resistance is the key to technical analysis. All technical analysis is based on knowing where the market will reach its’ lows (support) and where the market will reach it’s peaks (resistance).
Supports are the lows of the market. Supports are where the demand side (buys) are strong enough that they stop the price from going any further down. As a result, prices go back up. Sometimes, the support level can be predicted from past resistance levels and support levels. But more on that later.
Resistance is the opposite of support. Resistances are where the supply side (sell) are strong enough that they prevent the market from going up any further, thus causing the price to come back down. Resistance levels can often times be predicted by looking at the past support and resistance spots. More on this later.
Technical analysis is all about trends, and supports and resistances are the key part to trends. In a bull market (called an uptrend), resistance levels means that the market is taking a temporary pause from going up. Sometime later the market will break through the resistance level, and go further up. In a bear market (called a downtrend), support levels means that the market is taking a temporary pause from going down. Sometime in the future the market will break through the support level and continue moving downwards.
In an uptrend, each successive support level must be higher than the last one before it. However, in an uptrend, there are certain pauses where the price moves sideways for a while, and later resumes it’s upwards movement. In a downtrend, each resistance level must be lower then the previous one.
Support and Resistance Lines can Change Roles
Something interesting about resistance levels and support levels is that those lines are penetrated by a substantial amount, the reverse roles. This usually happens when a trend is changing. Look at the chart below.
To better understand support and resistance lines, and why they change roles, let’s first look at the investor psychology behind this.
Psychology Behind Support and Resistance Lines
All market action (price movement) is based on the psychology of the market players; the investors. Are the market players fearful, greedy, bearish, or bullish? None the less, support and resistances lines demonstrate a change in the general investor psychology towards the market.
Let’s begin with an example. In the market, there are three groups. The longs who have already bought into the market, the shorts who have already sold the market and are waiting for further price declines, and those who are unsure and have no position in the market.
The green line is the support, and the red line is the resistance.
So the market starts moving up from the support area. The longs (who bought near the support level) are happy and convinced that a new bull trend is beginning, and want to buy more. They want to buy more when the price falls back to the place where they last bought (which is the support line). As the markets get higher and higher, investors start selling. The shorts who are already short see that the price is falling (from the resistance line), and are thus convinced that a bear market is under way. Thus, they hope for the price to get back to the place where they shorted (the resistance line) and sell some more. That’s the cycle for why the resistance and support lines in a non trending market works. It’s all about investor psychology.
How to Determine the Significance of a Support or Resistance Line
The more trading that occurs at the support or resistance line, the more important it will be in the future.
The longer (time-wise) prices are stuck at the support or resistance level, the more important it will be. For example, if the price trades sideways at the $30 resistance line for 3 weeks, it will be more important than a price that trades sideways at the $22 line for 1 week.
Volume also tells the technical analyst how important a support or resistance level is. Heavy volume on the support line means that there was a heavy buying pressure there. Support or resistance lines with heavy volume are more important and will be harder to break in the future than those with little volume.
The third way to find the importance of a support or resistance level is to see how recently the trading took place. Because the investment markets are all about investor psychology, it stands to reason that the more recent the support or resistance area took place, the more important it will be.
Support Becomes Resistance
If prices start to fall beneath the previous support level, all those longs who bought into the support line realize that they’ve made a mistake. The longs desperately want the price to go back to the previous support level so that they can get out of the market at a break even point. That’s why once prices move back up to the previous support level, it turns into a resistance level because the longs sell at this point.
Nice, Fat Round Numbers
Humans have a natural attraction to round numbers such as 50, 100, 200, etc. These round numbers act as psychological support or resistance barriers. These round numbers are often used by technical analysts to make fantastic profits. For example, if prices are going up, they’ll have some resistance near the $100 level and likely come back down. However, if prices easily break through the $100 resistance level without hesitation, it means that the market will easily advance further.
The important thing in trading around the round numbers is that you should never place your buy or sell order exactly at the important round number. For example, if prices are falling to $100, don’t place your order right at $100. Many other investors may be buying at the $100 level, so the market may not actually fall to $100. Place your order a little bit above the $100 price level.
After a support or resistance level is penetrated, traders and investors have a natural instinct to question that new support or resistance level. For example, after the prices breaks through the support level, investors may question the new price and decide to buy, thus returning the price above it’s old support level. This is what technical analysts like to refer to as trader’s remorse, because investors regretted their past decisions, and prices return to the old support or resistance levels after a penetration. Here’s an example of trader’s remorse.
Now, what happens after trader’s remorse takes place is the determining factor. There are two choices. 1, that investors feel the new price is not justified, and the price moves back to it’s previous level. 2, investors accept the new price, price does not move back to previous level, and prices continue to go up or down according to whether they penetrated a previous support or resistance line.
Sometimes, a bull trap is created. This is when a price temporarily breaks through a resistance level, and then they move back into the previous price levels, thus leaving investors who bought after the penetration of the resistance level with a loss. See image below.
The same (or opposite rather) can be said about a bear trap. This is when a price temporarily breaks through a support level, and then they move back into the previous price levels, thus leaving investors who sold after the penetration of the resistance level with a loss. See image below.
So the big question concerning trader’s remorse is: how do we know if the breakout above or below the support or resistance line is a trap or not? How do we know if trader’s remorse is taking place or not? Look at the volume. If there is heavy volume when the price breaks out, then a real breakout is indicated. If there is low volume when the price breaks out, then traders remorse is often indicated.