Understanding support and resistance levels

So, we’ve seen how single and multiple candlesticks charts can form various patterns as the price of a stock changes. Now, we’ll look into two important concepts – support and resistance levels. Let’s look at an analogy to understand this concept better.

Reverting back to India’s favourite sport – cricket – let’s assume there are two batsmen named Vinod and Vikram. Now, Vinod is a hard worker and he puts in a lot of practice outside of the game. However, in spite of his best efforts, he’s never been able to hit a century in any of the matches he’s played. The most he’s scored has been 90 runs. He’s never been able to break past the 90-run mark.

Vikram, on the other hand, is a natural at the game. He does put in equal practice, but even when he’s not particularly in great form, his score has never fallen below 50 runs. In other words, he’s never scored less than 50 runs in any of the matches he’s played in.

You see, comparing these two players, it’s evident that for Vinod, the hard worker, the 90-run mark appears to be a point of resistance above which he cannot score, no matter how much he tries. But for Vikram, the natural, the 50-run mark seems to be the point of support that holds up his score, never letting it fall below that point, even when he’s not particularly prepared.

This, when translated into the share market, is what support and resistance are all about.

What are support levels?

Support levels are essentially the points on the price chart of a particular share or an index, below which the price of the asset refuses to fall. Here’s what generally happens before a support level is achieved.

• The price of the stock is on a downtrend.
• So, the demand for the stock rises, as more buyers rush in to purchase the stock at lower prices.
• At some point, the number of buyers becomes greater than the number of sellers. In other words, the demand starts to exceed the supply.
• So, the excess demand stops the stock price from falling further, and the price of the stock turns around and starts to rise instead.

What are resistance levels?

Resistance levels are the points on the price chart of a particular share or an index, above which the price of the asset refuses to rise. Here’s what generally happens before a resistance level is achieved.

• The price of the stock is on an uptrend.
• So, the demand for the stock falls, as fewer buyers are willing to purchase the stock at higher prices. However, more sellers are willing to sell their holdings for profits.
• At some point, the number of sellers becomes greater than the number of buyers. In other words, the supply starts to exceed the demand.
• So, the excess supply stops the stock price from rising further, and the price of the stock turns around and starts to fall instead.

Types of support levels

Support levels can be either horizontal or diagonal. Let’s look at the NIFTY support levels as an example for horizontal support levels. 

Here, in the image above, you can see that at two points, the price of Nifty 50 dipped down to around 11,470 and then stopped falling further. Instead, it started to rise back up after trading at around 11,470. When we identify these price action points and notice that they’re roughly at around the same price point, we call it a horizontal support level. 

Again, let’s look at NIFTY support levels as an example for diagonal support levels. 

As you can see, we can identify around four NIFTY support levels easily in this chart. The pattern, however, is not horizontal, because the support keeps increasing at each succeeding price action point. This essentially means that the market is on an uptrend, because even though the price of the share falls occasionally, the points at which it rises back up continue to increase.

In the image above, the first support level comes in at around 1,900. The next one is located at around 2,250. The third support level has increased to around 2,750, while the fourth has risen up to 3,500. By connecting these successive low points, we get a diagonal support trend line. 

Types of resistance levels

Just like support, resistance levels can also be horizontal or diagonal. Here’s an example of horizontal resistance. 

Here, in the above image, you can see that at three points, the price of Nifty 50 rose up to around 11,585 and then stopped going up any further. Instead, it started to fall after trading at around 11,585 at three consecutive points. Since these price action points that we’ve identified are roughly at around the same price point, we call it a horizontal resistance level. 

Let’s now see what diagonal resistance levels are like.

Here, in the image above, we can identify around four resistance levels easily. The pattern here is diagonal because the resistance keeps decreasing at each succeeding price action point. This essentially means that the market is on a downtrend, because even though the price of the share rises occasionally, the points at which it falls back down continue to decrease. In other words, the price tends to fall easily.

In the image above, the first resistance level comes in at around 11,300. The next one is located at around 11,250. The third resistance level has fallen to around 11,150, while the fourth has decreased further down to around 11,050. By connecting these successive highs, we get a diagonal resistance trend line. 

Support and resistance: A reversal of roles

So far, we’ve seen that the price of an asset rises back up at support levels and falls back down at resistance levels. However, there are times when these levels are broken. In other words, the price of the asset can occasionally continue to fall below a support level. When this happens, it’s known as a breakdown. And following a breakdown, the price action point that was earlier the support level then becomes the resistance level. 

Here’s an image of such a breakdown role reversal to make things clearer.

In the image above, you see how the price action point around 11,675 was earlier a support level? And once the price breached this support level, the same 11,675 and its nearabout values become action points that act as a resistance level.

Conversely, it can also happen that the price of an asset continues to rise past a potential point of resistance. Here, the price of the asset continues to rise past a level of resistance. When this happens, it’s known as a breakout. And following a breakout, the price action point that was earlier the resistance level then becomes the support level. 

Here’s an image of such a breakout role reversal to make things clearer.

How do support and resistance levels prove useful for traders?

Okay then, we’ve seen what support and resistance levels are, and how they form trends of different kinds. But what is the practical use of these metrics? Come, let’s find out.

Scenario 1:

• Say you’ve purchased a share of PVR Cinemas for Rs. 1,000. 
• By studying the weekly chart for that company’s share, you notice that currently, its support levels are concentrated at around Rs. 700. 
• Meanwhile, its resistance levels are concentrated at around Rs. 2,200.
• So, you know that with support levels being the minimum points below which a share’s price will not fall, the price of this share will likely not fall below Rs. 700 unless a breakdown occurs.
• Similarly, it may not rise past Rs. 2,200 in the near future unless a breakout happens.
• This means that the price of the share, which you purchased for Rs. 1,000, may not fall below Rs. 700 or rise past Rs. 2,200.
• So, you can use this information to set a target price at which to sell your share for a profit. You can also set a stop loss order at the lowest price that the share may touch.
• In this case, the resistance level will be the target price. And the support level will be the stop loss mark.

To summarise:

• Entry point: Rs. 1,000
• Target price/exit point: Rs. 2,200
• Stop loss mark: Rs. 700

Scenario 2:

• Now, say you’re going to do a short sale – where you sell first and then buy later.
• Assume that your entry point is again Rs. 1,500. This means that you’ve sold the share at Rs. 1,500. So, you need to buy the share later, at a lower price, to make a profit.
• By studying the weekly chart for that company’s share, you notice that currently, its support levels are concentrated at around Rs. 800. 
• Meanwhile, its resistance levels are concentrated at around Rs. 2,000.
• So, the price of this share will likely not fall below Rs. 800 unless a breakdown occurs.
• Similarly, it may not rise past Rs. 2,000 in the near future unless a breakout happens.
• This means that the price of the share, which you sold for Rs. 1,500, may not fall below Rs. 800 or rise past Rs. 2,000.
• So, you can use this information to set a target price at which to buy your share for a profit. You can also set a stop loss order at the highest possible price that the share may touch.
• In this case, the support level will be the target price. And the resistance level will be the stop loss mark.

To summarise:

• Entry point: Rs. 1,500
• Target price/exit point: Rs. 800
• Stop loss mark: Rs. 2,000

Wrapping up

Well, that brings us to the end of our chapter on support and resistance levels. It’s a simple enough concept that can reveal a great deal of information about the  trends in which a share’s price moves. We’ll follow this up with the Dow Theory, which forms an integral part of technical analysis.

A quick recap

• Support levels are the points on the price chart of a particular share or an index, below which the price of the asset refuses to fall. 
• Resistance levels are the points on the price chart of a particular share or an index, above which the price of the asset refuses to rise.
• Support levels can be either horizontal or diagonal.
• A horizontal support level occurs at around the same price point.
• In diagonal support levels, the support keeps increasing at each succeeding price action point. This essentially means that the market is on an uptrend, because even though the price of the share falls occasionally, the points at which it rises back up continue to increase.
• Resistance levels can also be either horizontal or diagonal.
• A horizontal resistance level occurs at around the same price point.
• In diagonal resistance levels, the resistance keeps decreasing at each succeeding price action point. This essentially means that the market is on a downtrend, because even though the price of the share rises occasionally, the points at which it falls back down continue to decrease. In other words, the price tends to fall easily.
• There are times when support levels are broken. In other words, the price of the asset can occasionally continue to fall below a support level. When this happens, it’s known as a breakdown. And following a breakdown, the price action point that was earlier the support level then becomes the resistance level. 
• It can also happen that the price of an asset continues to rise past a potential point of resistance. Here, the price of the asset continues to rise past a level of resistance. When this happens, it’s known as a breakout. And following a breakout, the price action point that was earlier the resistance level then becomes the support level.