Support and Resistance
Many of the greatest sport coaches of all time share a common characteristic:, their obsession with the fundamentals of their sport. Whether it is passing in basketball, tackling in football, or fielding in baseball, these coaches spend what may seem to an outsider to be an inordinate amount of time in these areas. They preach fundamentals during the off season, during preseason, and during practice with the hope that when the game begins, these fundamentals will be second nature to their players.
One can find many parallels between sports and trading in the financial markets, but perhaps there is nothing more appropriate than the importance of learning fundamental principles in order to be successful. In time, traders in the financial markets can find many sophisticated manners in which to trade, and may have elaborate indicators that aid them in their trading. All of these advanced methods and techniques will be nothing but a detriment if the fundamentals of trading are not learned, or if they are later ignored.
Among the fundamentals of technical trading lie the principles of support and resistance. These are among the first concepts taught to new traders interested in learning about technical analysis, and these concepts should be applied to your trades as long as you are an active trader. Support and resistance is defined as, “a concept in technical analysis that the movement of the price of a security will tend to stop and reverse at certain predetermined price levels"(en.wikipedia.org/wiki/Support_and_resistance). In other words, in technical analysis, it is believed that securities have predetermined price levels where they stop falling (i.e., find the support necessary to stop falling), and predetermined price levels where the stock will reverse its upward climb (i.e., when it meets a price level that resists further climb upward).
So, if stocks tend to stop and reverse at certain levels, one can immediately see how this can benefit their own trading. If true, these price levels of support and resistance could give excellent signals of when to buy and sell the security in question. This is exactly what support and resistance mains function is for those that engage in technical analysis. It is one tool in the technical trader's toolbox that allows him/her to increase the probability of a winning trade. Probability is the key word here, as there is nothing in technical analysis that guarantees certain price action will occur. A security may have hit approximately $100, three times in a row (resistance) before falling to $95, finding support. This does not guarantee that it will stop climbing if it hits $100 again, nor does it guarantee it will stop falling if it hits $95. However, those that adhere to technical analysis know that these repetitive patterns have meaning, and often look to these support and resistance zones first before engaging in any other analysis.
While on rare occasion support and resistance will land on nice exact numbers, it is better to think of these concepts as a zone or a range. For example, in Figure 1, we see that this particular security was falling downward until it hit point "A." A couple of weeks later, it hit that same approximate price range again at point "B," before climbing up again. For simplicity, we can draw a line meeting these points, which creates a zone or level of support (at least in the short term) that can give us an indication of what might occur if it were to fall to this level again.
Figure 1
If someone trained in technical analysis was following this security or came across it in one of their scans, they would be very interested if the security climbed short term only to fall to that same support range again that it found in points A and B. They would be looking for one of two things to happen: either it will find support at that range again, indicating a buying opportunity, or support will fail, which could indicate an opportunity to short the stock. As we look at Figure 2, we see that it indeed found support again at the approximate support zone before climbing up again.
Figure 2
This is a simple straightforward example of support; however, it does demonstrate how powerful support and resistance can be when properly identified. While in this example the support zones are clearly established, sometimes it is not so straightforward. The beginning eye may not find support and resistance zones, or may wrongly label certain price action as support and resistance. Other times, identifying support and resistance is just as easy as identifying support on this chart. If you are new to technical analysis, find examples that are clear cut, and have easily identifiable zones. In time, you will be able to identify short- and long-term support and resistance, draw support and resistance lines in up and downtrends, and combine numerous other indicators that will strengthen the probability of a winning trade.
A final note on a question that many new to technical analysis ask: after seeing securities behave like this, they are curious to what factors make a security behave in this fashion. If a stock rises to hit approximately $100 four times in a row before falling in the short term each time, why does it do this? There is nothing mystical going on, simply a combination of supply and demand, human emotion, and other technical traders influencing the price action. All of these create support and resistance barriers that can benefit you in your trading. If you are not comfortable identifying support and resistance zones immediately when looking at a chart, then you need to put in some time and practice. Ignoring support and resistance is like a basketball player that can't dribble.