Support, Resistance, and Rounded Numbers
The number 10 is often the first goal that a parent sets for their child when learning how to count. Wild applause and hugs usually follow when the child counts to 10 for the first time. As time passes, there are subsequent attempts to teach the child to count to 20, 30, 50, and eventually, 100. These rounded numbers, typically to the closest multiple of ten or hundred, are usually the goal.
Rounded numbers also dominate our currency. After the $1 and $5 bills, bills typically jump by tens—$10, $20, $50, and $100 bills. Try to imagine a society in which $32 bills and $113 bills circulate. Even the simple $2 bill, while still in circulation, fell out of favor with the American public.
Whether it is learning to count, our currency, or the special emphasis we put on new years that start a new decade, society seems to favor rounded numbers to ten or hundred. Whether this speaks to the simplicity of the human mind or our need for a semblance of order in society will be a conversation left for another time. What we care about as traders is whether it is possible to capitalize with this fascination with rounded numbers.
Support and Resistance
A quick review of support and resistance: 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). An example of a security finding support can be found in Figure 1.
Figure 1
Support and resistance is one of the fundamental foundations of technical analysis. If there are indeed price levels in which stocks or other securities have a high probability of stopping the current movement and reversing their direction, then it presents opportunities to buy or sell at those price points. If a stock has found short-term support at $88, then this can be used as one indicator to buy the stock at that level. Along the same thought process, if the stock has found resistance at $88, then this can be used as an indicator to sell that stock if it approaches that price point again.
Traders should never buy or sell simply based on support and resistance, as it just one of your tools in your technical trader toolbox. With that said, it is a powerful tool and one that should be used in nearly every trade you make. It can help identify entry and exit points, and increase the probability of making a winning trade. And as we know, increasing probability is what successful trading is all about.
Predetermined Price Levels
So our basic definition of support and resistance states that the price of a security will "tend to stop and reverse at certain predetermined price levels." So, what determines these predetermined price levels? There is no singular answer to this question. Short and long-term highs and lows for the security in question can influence these potential price levels. Also, there is no magic formula to determine what a particular security’s short-term support and resistance levels are. A security may find resistance at 88.50, and then break through that and find resistance at 94.00 the next week.
Conversely, a downtrending stock may find support at 22.00 one week, only to have that support broken and find its new support level at 19, or 18, or 16.54. Trying to guess where the stock’s support level is going to be is what the amateurs do. The professionals wait to let the support level set before entering potential trades.
Support, Resistance, and Rounded Numbers
So while there is no magic formula to determine what a particular securities short-term support and resistance levels are, a funny thing happens to securities when they hit rounded numbers. When a security is hitting a rounded number like 50 or 100 for the first time (or first time in an extended period of time), there is a tendency for support and resistance to form at these numbers at a significantly higher rate than other random numbers. To fully grasp why this occurs, you cannot forget that the markets are driven by human beings who carry with them many trader’s nemesis—human emotions.
For example, let's suppose company XYZ is on a bullish tear and approaching 100 for the first time. This is a milestone for many companies and there is a tendency for traders to pause at this moment. Many stocks in this situation will find resistance at 100, and a short pullback may occur. After a few days the resistance level is often tested again. Either resistance will hold again, resulting in either stagnation or a pullback, or resistance will be broken. When resistance is broken, it often is an excellent entry point as a possible breakout could be occurring.
Suppose company XYZ has been downtrending for some time, and is approaching the $50 level. Barring catastrophic news, stocks in this situation often find support in the short term at these nice rounded numbers. Support is often tested numerous times; if it finally falters, then it provides an excellent indicator that the stock is heading further south. If support holds for an extended period of time, many excellent short-term trades may present themselves.
As with all tools in technical analysis, one should never simply buy or sell based on whether a stock is approaching a rounded number; it is simply one tool of many to increase your chances of success. Take the time to look back at stocks on your watchlist to see how they performed when they approached 30, 40, 50, and 100 for the first time. It will not only give you further insight into the stocks you are tracking, but you are likely to find real historical examples of how support and resistance form at these easily identifiable numbers. Remember, books are written entitled Dow 20,000, not Dow 18,765.