Support and Resistance are two of the most closely watched and utilized technical indicators. Although difficult at times, identification of these key indicators is an essential ingredient to succesful technical analysis and even being aware of their existence and location can greatly improve your forecasting and analyzing abilities. Both are price levels at which either supply or demand for a security is often perceived greater than the other and this in turn can affect the movement of that security.
Support: is the price level at which demand is thought to be great enough to prevent the price from declining any further because as the price of the sock is getting cheaper buyers are more inclined to buy and sellers are less inclined to sell. Support is determined by drawing a line connecting the low points (the valleys) on a stock chart. As a stock price declines, investors are mindful of these prior price reversals. It’s almost as if there was some kind of price memory inherent in a stock. Perhaps there is. Human behavior follows certain predictable patterns much like memory metal.
Resistance: is the price level at which supply is thought to be strong enough to keep the price from rising any further because as the stock gets more expensive buyers are less inclined to buy and sellers are more inclined to sell. It’s the reverse of the phenomenon noted above. Resistance is determined by drawing a line connecting the high points (the peaks) of the stock price. Stock price action exhibits common behavior of struggling to exceed the peak price. Often times this market action is interpreted as unhappy buyers who bought near the top are waiting to get even and shed the stock.
When the price of the security is approaching an important support level, it can be an alert to watch for extra buying power and potential reversal. And when the price is approaching an important resistance level you need to watch for extra selling. Keep in mind that the price may briefly go beyond your established support and resistance levels so it is a good idea to have a price “zone” rather than a specific level. Once these “zones” are broken than you will need to set a new one because the relationship between supply and demand has been altered. Broken support levels often times become the new resistance levels and vice-versa.
Often times stocks will exaggerate their movement at these key junctions. In fact you can make a logical argument that buying a stock after it makes new highs is the best time. After all the great winners of the past ALL made many new highs by definition. This style of investing is often associated with “momentum investing”. You will often see a sudden spurt in volume and quick price appreciation when stocks “break out”. There are numerous stock screens designed to rapidly pick out in real-time this price behavior although it may be a better strategy to trade against this behavior and short them. Following crowd behavior is usually the wrong thing to do.
Moving Averages can also be helpful when used along with support and resistance. The moving average is simply a line chart that shows the average value of a security over a series of periods. They do not predict the price direction, rather they define the current direction with a lag, because they are based off of past prices.
Moving averages can act as both support and resistance when price approaches them. But unlike regular support and resistance levels, they do not remain at one stationary level and can also move on your chart. Simple averages help form the building blocks to many other technical indicators and are great for helping define potential stationary support and resistance levels as well because they act as a barrier where prices have already been tested.
I often compare moving averages to sign posts along the road. If you are driving at 55 mph and you enter a speed zone marked 20-mph, traffic comes to a sudden crawl. Why is this? Of course the answer is simple. Predictable crowd behavior. Technical analysis is as much about human behavior as price patterns. There are many well-known technical indicators that Chartists follow but most of them are too esoteric and practiced by few traders. The two that are universal are moving averages and support/resistance. These are the sign posts everyone is seeing.
But a moving average can be any number of days, months, weeks, etc that fit into your formula. If you are asking how do you know which one works, you are missing the point. None of these integers work. Just because you divined some price pattern that held up to backtesting doesn’t mean anything. It’s not the predictive nature of your moving chart that is important. It’s just the simple fact that others are looking at the sign posts along the way. And the signs that most people are looking at are the 50 and 200 day moving averages. So that’s what we watch.
So just like support and resistance that we talked about earlier, stock price exhibit short-term predictable responses at the 50 day and 200 day moving average lines. These lines drawn by the computer become support and resistance lines just like the lines drawn from peak to peaks and valley to valleys.
Although you should never make a call simply on what a technical indicator is telling you, having an understanding of these simple concepts can greatly improve your analysis of a security. To learn more about technical analysis please review our Investment Survival Guide, or click here: