Support and Resistance: Meaning, Role, Strategies and Limitation

In the last segment, we got insights into reading stock charts. While this may have offered you the confidence to invest or trade in stock markets, other important concepts can equip you to make better trading decisions. Today, we will explore one such essential concept: support and resistance.

Traders use support and resistance levels to guide them through the market flows that may be in many directions.

As much as support and resistance are technical terms, it is about psychologically understanding why the market moves in certain directions. Traders and investors base their decisions on past experiences and changing circumstances to forecast where the market can move next successfully.

Support and resistance act as reliable signals with useful information that can point towards possible price changes and help traders decide. This chapter will delve into the nuances of support and resistance.

What is Support in Trading? 

Support is a fundamental concept in trading that serves as a critical level where the demand for an asset outweighs the supply, thereby preventing its price from falling further. 

Support levels often align with previous lows in the price chart and mark points where demand has historically halted downtrends. These levels serve as historical references indicating strong buying interest.

Traders commonly perceive support levels as favourable buying opportunities, anticipating a potential price rebound. This collective sentiment reinforces the significance of support zones as traders react to the perceived value of the asset at these levels.

Picture a ball bouncing on the ground. Each time it hits the ground, it encounters support, preventing it from sinking further. Similarly, in trading, when prices touch a support level, buyers enter the market, causing prices to rebound. This creates a visible "floor" on the price chart, signalling an area where demand exceeds supply.

Consider a stock experiencing a prolonged decline but reaching a historical support level. Traders viewing the stock as undervalued may initiate buying activity, generating upward pressure on the price. As more buyers participate, the stock's decline halts, and it begins to rise thus showing the strength of the support level.

By identifying and comprehending support levels, traders can anticipate potential buying opportunities and effectively manage risk.

What is Resistance in Trading?

Resistance acts as a formidable barrier above an asset's price, impeding upward movement and serving as a pivotal indicator of where selling pressure surpasses buying pressure.

Resistance levels typically correspond with previous highs in the price chart, representing points where selling pressure has historically halted uptrends. These levels serve as historical benchmarks denoting areas of strong selling interest.

Imagine trying to jump and touch a ceiling above you. Each time you leap, you encounter resistance, preventing you from reaching higher. Similarly, when prices approach a resistance level in trading, sellers enter the market, causing prices to stall or reverse. This creates a visible "ceiling" on the price chart, indicating an area where supply exceeds demand.

Consider a stock experiencing a strong uptrend but encountering resistance at a historical level. Traders perceiving the stock as overvalued may initiate selling activity, leading to downward pressure on the price. As more sellers participate, the stock's upward momentum halts, and it begins to retreat, underscoring the strength of the resistance level.

By identifying and understanding resistance levels, traders can anticipate potential selling opportunities and effectively manage risk.

Methods To Identify Support and Resistance

While identifying support and resistance levels may seem complex at first glance, several straightforward methods can help traders pinpoint these key levels on price charts.

• Understanding Significant Price Levels

Significant price levels are key points on a price chart where the market has previously reacted strongly. These levels are crucial because they often indicate areas where traders have historically made important buying or selling decisions.

• Previous highs:

These are price levels that the market previously reached and then turned downwards. These highs represent points where selling pressure was strong enough to stop the price from rising further. As a result, these levels are considered resistance levels. When the price approaches a previous high, traders may anticipate selling pressure to once again push the price downwards.

• Previous lows:

Previous lows on a chart represent price levels where the market previously bottomed out before bouncing back upwards. These lows indicate areas where buying pressure was sufficient to prevent the price from falling further. These levels are considered support levels. When the price approaches a previous low, traders may anticipate buying pressure to push the price upwards once again.

These significant price levels can be identified by visually scanning the price chart and noting where the price has reversed direction in the past. Areas where the price has repeatedly stalled or reversed are likely to be significant and may serve as potential support or resistance levels in the future.

• Horizontal Lines Method

The horizontal lines method is one of the simplest and most widely used techniques for identifying support and resistance levels. To apply this method, traders look for significant price levels where the market has previously found support or resistance. These levels are typically identified by examining previous highs and lows on the price chart.

Once significant levels have been identified, traders draw horizontal lines across these levels on the chart. The lines should be drawn in such a way that they connect multiple highs or lows, indicating the strength of the support or resistance level.

Support levels are drawn horizontally across previous lows, where buying pressure has historically prevented further price declines.

Resistance levels are drawn horizontally across previous highs, where selling pressure has historically halted further price increases.

When drawing these lines, it's essential to ensure they accurately capture the price action and align with multiple price points to confirm the significance of the level.

The above chart is a classic example of horizontal lines. Traders can use charting software or platforms that allow them to draw horizontal lines easily. Once drawn, these lines serve as visual references for potential areas of support and resistance on the price chart.

• Trendlines Method

The trendlines method is another popular technique for identifying support and resistance levels, particularly in trending markets. Trendlines are diagonal lines drawn on a price chart to connect consecutive lows in an uptrend or highs in a downtrend.

In an uptrend, traders draw a trendline by connecting two or more consecutive higher lows as shown below. This line acts as dynamic support, indicating the upward trajectory of the trend.

In a downtrend, as you can see in the example below, traders draw a trendline by connecting two or more consecutive lower highs. This line acts as dynamic resistance, indicating the downward trajectory of the trend.

Trendlines can help traders identify potential areas of support or resistance within a trend and anticipate price bounces or reversals.

When prices approach a trendline, traders pay close attention to how the price reacts. A bounce off an upward trendline suggests bullish momentum, while a rejection from a downward trendline suggests bearish pressure.

It's important to note that trend lines are subjective and can vary depending on how traders draw them. However, trendlines drawn using widely recognised swing points tend to carry more significance.

Traders can use trendlines in combination with other technical analysis tools to confirm potential support or resistance levels and make more informed trading decisions.

• Support and Resistance Zones

Zones resemble Horizontal Support/Resistance levels, but they offer more flexibility. Unlike specific price levels where you anticipate a precise price hit and reversal, zones are broader areas where you expect some form of price reaction or hesitation.

When the price moves past a resistance zone, it might turn into a new support zone. Similarly, if it tests a support or resistance zone multiple times without breaking it, that zone becomes stronger. When a support or resistance level breaks, the strength of a subsequent move depends on how well the support or resistance is held before.

• Moving Averages Method

Moving averages are another tool that traders use to identify support and resistance levels on a price chart. They smooth out price data by calculating the average price over a specified period, such as 10 days or 50 days. Common types of moving averages include the simple moving average (SMA) and the exponential moving average (EMA).

In an uptrend, a moving average can act as dynamic support, with prices finding support near the moving average as it trends higher. Conversely, in a downtrend, a moving average can act as dynamic resistance, with prices encountering resistance near the moving average as it trends lower.

Traders pay close attention to how prices interact with moving averages. A bounce off a moving average suggests support or resistance, while a breach of the moving average may signal a potential trend reversal.

Traders often use multiple moving averages of different time periods to identify potential support and resistance levels. For example, a trader may use a shorter-term moving average (e.g., 20-day SMA) along with a longer-term moving average (e.g., 50-day SMA) to confirm potential support or resistance zones.

It's important to note that moving averages may not always provide timely signals. Therefore, traders often use moving averages along with other technical analysis tools for confirmation.

• Confirmation With Price Action

Once support and resistance levels have been identified using various methods, it's crucial to confirm their validity through price action. Price action refers to how the price of an asset behaves at specific levels, including support and resistance zones.

Traders look for signs of price reactions, such as bounces, reversals, or breakouts, at identified support and resistance levels to confirm their significance.

Successful bounces or reversals from support or resistance levels validate their importance and indicate that market participants are reacting to these levels.

Conversely, breakouts occur when the price decisively moves above resistance or below support, suggesting a potential shift in market sentiment.

Traders pay close attention to the volume and the strength of price movements when confirming support and resistance levels. Higher trading volumes and strong price movements validate the significance of these levels.

It's essential to wait for confirmation signals before making trading decisions based on identified support and resistance levels. Rushing into trades without confirmation can increase the risk of false signals and losses.

Traders can also use additional technical indicators, such as oscillators or chart patterns, to confirm support and resistance levels and enhance their confidence in trading decisions.

Support and Resistance Role Reversal

In technical analysis, we believe that when a support or resistance level is broken, its role changes. When the price goes below a support level, that level often turns into resistance. And when the price goes above a resistance level, it usually becomes support. This change happens because moving past these levels shows a change in market forces, making the old level switch its role.

• Support to Resistance Reversal:

When a support level is breached, and the price falls below it, that level may become a new resistance level. Traders who previously relied on the support level to enter long positions may now view it as a barrier to further price advancement. The market sentiment shifts as traders who missed the initial breakout may attempt to sell at the former support level, expecting resistance.

• Resistance to Support Reversal:

Conversely, when a resistance level is breached, and the price rises above it, that level may turn into a new support level. Traders who previously sold at the resistance level to profit from price reversals may now see it as a potential entry point for long positions. The market sentiment changes as traders who missed the initial breakout may seek to buy at the former resistance level, expecting support.

Recognising support and resistance reversals is essential for traders because it offers valuable insights into possible shifts in market direction and sentiment. Traders frequently keep a close eye on these reversal points and adapt their trading strategies accordingly to take advantage of new opportunities in the market.

Support and Resistance Trading Strategies

Trading strategies utilising support and resistance levels can vary based on individual trading styles and preferences. Here are some common strategies:

• Range Trading

This strategy involves buying near support and selling near resistance to capitalise on price oscillations within a defined range. Traders set stop-loss orders outside the range to manage risk in case of a breakout.

• Breakout Trading

Breakout traders aim to profit from significant price movements when the price breaks through a support or resistance level. They wait for a clear breakout above resistance or below support and enter trades in the direction of the breakout. Stop-loss orders are used to manage risk, and trailing stop-loss orders may be employed to lock in profits as the trend develops.

• Trendline Strategy

Trend traders use support and resistance levels to confirm the strength of an existing trend and identify potential reversal points. They look for situations where the price bounces off support or resistance levels in the direction of the prevailing trend to confirm its continuation. Trades are entered with the trend, and stop-loss orders are placed to manage risk in case of a trend reversal.

These trading strategies offer various approaches to using support and resistance levels effectively in trading. Each strategy has its own set of rules and risk management techniques, and traders may choose the one that best fits their trading style and objectives.

Limitations of Support and Resistance

Recognising the limitations of support and resistance levels is important for traders to manage risk and make informed trading decisions effectively. Let's look at them:

• Subjectivity: Identifying support and resistance levels can be subjective and open to interpretation, as different traders may draw lines differently based on their analysis.
• Not Always Reliable: Support and resistance levels are not always reliable indicators of future price movements. Price may break through these levels unexpectedly, leading to false signals.
• Whipsaws: In choppy or range-bound markets, support and resistance levels can result in whipsaws, where price repeatedly tests these levels without a clear breakout, leading to losses for traders.
• Backward-Looking: Support and resistance levels are based on historical price data, which means they may not accurately predict future price movements, especially in rapidly changing market conditions.
• Lack of Precision: Support and resistance levels are not precise points but rather zones or areas where price may react. This lack of precision can make it challenging to determine entry and exit points with accuracy.
• Dynamic Nature: Support and resistance levels are dynamic and can change over time as market conditions evolve. Traders need to continuously monitor and adjust these levels, which can be time-consuming.
• Not Standalone Indicators: You should use support and resistance levels together with other technical indicators or chart patterns for better signals. Just using these levels by themselves might not give the full picture.
• Market Sentiment Shifts: Sudden shifts in market sentiment or unexpected news events can invalidate previously identified support and resistance levels, leading to rapid price movements that catch traders off guard.

By combining support and resistance analysis with other technical and fundamental factors, traders can improve the accuracy of their predictions and reduce the impact of these limitations on their trading strategies.

Wrapping Up

The key to using support and resistance in trading is finding the right balance between leveraging them and being aware of their limitations. In the next chapter, we will study support and resistance role reversal in detail.