Support & Resistance: Understand in Detail

If you had a method to arrive at the potential future prices of securities, wouldn’t life be much easier? Well, that is the essence of technical analysis. And support and resistance are two key foundational concepts commonly used by traders to do just that. But what are these concepts?

In simple terms, Support is the area beyond which the price potentially should not fall & and Resistance is the exact opposite, that is, the price should potentially not cross this ceiling. These price barriers are formed due to higher levels of buying & selling near the Support and Resistance. Although these act as primary technical indicators for buying and selling, they are not always precise. Support and Resistance are dynamic, which means weak Support and Resistance levels can be easily broken and strong Support and Resistance levels are considerably harder to break. But if fluctuations in either direction do break these support or resistance levels, they are known as “breakouts”.

What is a Support Level?

As we all know, a market does not fluctuate based on some scientific law but based on trading psychology. This is why understanding the concept of support is easy but challenging to master. On a fundamental level, support is the level at which the price finds a “floor.” So, support can either be seen as a level or a zone on a chart. In any case, this level can help you identify the amount of demand in the market.

What Is Resistance?

On the other hand, resistance is the absolute opposite of support. So, when traders buy at certain price levels in the market, a ceiling price is formed. This zone of supply is known as resistance. Now, there may be cases wherein the price may go beyond your resistance level; this is ideally known as a breakout. Under these particular circumstances, your resistance could become your new support .

How to Identify Support and Resistance levels?

Identifying support and resistance levels can be a subjective process that varies depending on the trader's approach. However, certain techniques can make it easier to identify these levels accurately rather than randomly drawing lines on a chart. Here are a few additional techniques that you can use to properly identify support and resistance levels.

Trendlines

A trendline is a visual representation of support and resistance in any timeframe. We all know that even though markets stay in the same range, they tend to have an uptrend or a downtrend. To identify these trends, we use a trendline. This is an upward or downward-sloping line that indicates the direction of the price of a stock in the market. When trying to find support and resistance levels, make sure the price touches the trendline thrice – or at least twice - to confirm your hypothesis.

You can also make use of channels to indicate support and resistance levels. A channel is two parallel lines going in a particular direction. Assume the market is going up today; in this case, you would have a rising channel. Whereas if the market was falling, you would have a falling channel.

Round Numbers

In most marketing classes, we are taught about pricing psychology. Which states that a consumer is likelier to buy a product priced at ₹99 rather than something at ₹100.

Unlike this, the stock market functions in a completely different manner. Most traders usually buy a stock that is priced at a round number, for example, ₹100 or ₹150. This is mainly because people find it easier to visualize the market at a round number; this is just one reason. The other reason is that many traders set their target levels or stop losses at that round number price level. So, imagine millions of traders suddenly selling their stocks once the target level is hit. This would take a considerable number of buyers to absorb the sales, which would then create a potential resistance level in the market.

Moving Averages

An alternative to trendlines is the Moving Average indicator. The moving average indicator helps traders predict future short-term momentum in the market. The moving average indicator is a technical indicator that smooths out past price data by constantly creating an updated average price. The moving average indicator is a single line that acts as both the support and resistance level.

Other Indicators

For example, the Fibonacci retracement is a tool many short-term traders use. Assume that today, NIFTY 50 has a strong rally and has gone up to ₹21700 from ₹21500, and after reaching a peak of ₹21700, the prices start to consolidate. Let’s consider that there is a trader who believes the market will continue this bullish trend and wants to enter a trade. Now, this is where a trader could use it to identify the levels of support and resistance.

Fibonacci retracement levels at 23.6%, 38.2%, 50%, 61.8%, and 78.6% help traders determine support and resistance, set targets, and stop losses. As always, a trader must be cautious while trading; it may happen that after a bull run, the market could dip, and prices may fall.

Trading Ranges

And this finally brings us to the most commonly practiced Support and Resistance trading strategy, i.e. Range Trading. Herein traders enter long when prices bounce back from the support and go short when prices pull back from the resistance. This is beneficial only in range-bound securities. An important aspect to keep in mind is that in a downtrend going long at the support would be risky as the support may break and the same is the risk with going short on a price near the resistance in an uptrend. To not fall prey to such mistakes, a trader should look out for major support and resistance levels and volumes that is currently being traded.

Support and Resistance Reversals

Let's get a clearer view of support and resistance reversals with the help of a little walkthrough. Mr. A is a trader in the market. Mr. A has a share in Company X, which he bought at Rs. 10 in March. Now he realizes that between March and June, the share (in an uptrend) fluctuated between Rs 10-15 but did not break out until June. Here, the Rs 10 level acted as a support price and the Rs 15 level acted as the resistance. Each time the share gets closer to the support, traders tend to see it as a suitable entry point and hence we see a pullback in the price due to a high buyer concentration. In the same manner, whenever the price approaches the resistance, traders who bought the security near the support levels tend to sell it and hence the price is pushed back down due to high seller concentration. Subsequently, Mr. A noticed that once the share had its breakout the resistance i.e. Rs 15 became the new support for the share & a new resistance level formed at Rs 20. But be careful, for this may not always happen!

How Can Identifying Support and Resistance Levels Help Traders?

Support and resistance levels can help a trader identify when to buy or sell a stock at a potentially appealing target price. For example, if a trader wants to sell his stock after holding it for a while, he could use the current resistance level as it suggests an attractive selling point in the market. And if a trader wants to buy a stock in the market, he could use the support level to identify a good time to buy. As seen above, there are various methods by which a trader can identify support and resistance to make an informed trade. Short-term or swing traders often use this to locate entry and exit points.

How Can Market Psychology Influence Support and Resistance Levels?

As we know, the market is not entirely run on technical factors but also based on a trader's various emotions and behavioral characteristics. This is where market psychology and behavioral finance come into play. Let's take Anchoring, for example; this is when people assign some sort of meaning or significance to arbitrary numbers. There might also be an instance where a previously identified support and resistance could be future support and resistance. In addition to this, round numbers could also serve as support and resistance levels as they are psychologically driven anchors.

What Happens if a Price Breaks Through its Support or Resistance?

Any kind of breakout from a support or resistance could be labeled as a trend reversal. For instance, if support is broken, it could imply a new level of resistance, but if resistance is broken, it could suggest a new support level for the short term.

Key Takeaways

• Support and Resistance are price areas
• Support and Resistance are dynamic and consist of weak and/or strong Support and Resistance levels
• Weak Support and Resistance levels break easily, Major Support and Resistance levels either lead to trend reversals or breakouts in case of high buyer/seller concentration
• Support and Resistance levels help you to identify entry and exit points

Conclusion

Now that you know the basics of support and resistance, you can move to more advanced methods such as moving averages as support and resistance, or using Fibonacci numbers. Moreover, most technical tools have some form of Support and Resistance beaded into it and hence it's important for every trader to understand how they work.

In short, support can be considered a floor under the price, while resistance is the ceiling above the price. And since the market continuously moves, the support and resistance levels do, too. In any case, you should make sure to use proper trading strategies and indicators to further enhance your decisions before buying a stock.