Prices move in a series of peaks and troughs. The direction of the peaks & troughs determine the direction of the trend.
These troughs are also called as support or reaction lows. The term is self-explanatory. It is a level that provides support to a falling market. It is an area or level which shows that buying level is sufficient to absorb the selling pressure. As a result, decline is halted & prices move back up again. Usually a support level is identified beforehand by a previous reaction low.
The peaks in a chart are also called as resistance. It is opposite of support and represents a price level or an area where selling pressure overcomes buying pressures & prices are turned back. A resistance level is identified by a previous peak.
In a uptrend, resistance level pushes that trend but are usually exceeded at some point. Similarly, in a downtrend, support levels pauses the decline but are not sufficient to stop the decline permanently. Each time a previous resistance peak is being tested, the uptrend is in a critical phase. Failure to exceed a previous peak is usually the first warning of the changing trend. Similarly failure falling below the previous low may suggest the change of downtrend.
Psychology of support and resistances:
Assume that there are three categories of investors:
Let’s assume markets move higher. The longs are happy but have regrets of not buying more. Shorts now realize that they are on the wrong side of the market. The shorts want the prices to go back below to the support levels so that they could get out of their position. The undecided now realize that the prices will move higher and wait to buy the next dip in prices. All groups are resolved to buy. They have vested interest in that support area.
The more trading takes place in that support area, the more significant it becomes because more participants have a vested interest in that area.
Support becomes resistance
So far we have defined support as a previous low & resistance as a previous high. However, this is not always the case. This leads us to one of the more interesting & lesser known aspects of supports & resistances, “The reversal of roles”. Whenever a support or resistance level is penetrated, they reverse their roles & become the opposite. In other words , support becomes resistance and resistance becomes the support.
After a significant penetration the trends reverse. But what is significant? Some are 3% for short terms, some use 1%. In reality, each analyst must decide for himself what constitutes a significant penetration.
Supports and resistances are fun, basic & logical. Understanding them is more logical & psychological than just looking at charts. Unfortunately, we live in a fast-paced world of financial markets, where we tend to rely heavily on chart terminology and short-cut expressions that overlook the underlying forces that created the pictures on the charts in the first place.