Contents of this article
What are support and resistance?
One of the best ways to set price targets is to use support and resistance zones. Support and resistance are specific price zones on a historical chart where price is expected to reverse or slow down before preparing for a new trend (or moving sideways). A support zone is where buyers are expected to be stronger than sellers. Conversely, a resistance zone is where selling pressure is expected to overwhelm buyers.
In this article, we take a closer look at these two concepts and how they are applied in technical analysis.
What is resistance?
As the name suggests, resistance is what stops price from rising higher. A resistance level is a price zone on the chart where traders expect supply (selling pressure) to strengthen and overwhelm demand for the stock. A resistance level is therefore always above the current market price.
There is a high probability that price will rise to the resistance level, test it, absorb the available supply and then fall back. Resistance is therefore one of the important technical tools that market participants watch in an uptrend, where it acts as a sell signal.
Look at the chart below: the price zone around 18.8–19.6 acts as resistance. In the last three times price approached this zone, selling appeared and price reversed. Technical analysts generally believe that history tends to repeat itself, so price is quite likely to reverse lower again when it approaches this zone in future, and the 18.8–19.6 zone shown in the chart acts as a reasonable resistance.
Suppose price and indicators at the current level of 15.6 (below resistance) give a buy signal; we set up the trade with an entry and a stop-loss. Using what we have just learned about resistance, we can now set 19 as a realistic take-profit level for this trade. The reason is simple: the resistance level suggests a likely reversal, at least in the short term.
What is support?
In contrast to resistance, support is a buffer zone that holds price up and stops it from falling further. A support zone is a price zone on the chart where traders expect demand (buying pressure) to strengthen and overwhelm supply for the stock or index. So whenever price falls to the support line, it tends to bounce back. A support level is always below the current market price.
There is a high probability that price will fall to the support zone, test it, absorb the available demand and then start to rise. Support is one of the important technical zones traders look for in a downtrend, and it can be used to identify buy signals.
In the chart below, the 16–17 price zone acts as support, because price has fallen to this zone and bounced many times before. Traders all expect history to repeat, so they all buy when price falls to this level, causing buying to overwhelm selling and price to reverse – exactly as a support zone is defined.
A support level can be used to enter a buy order on a stock.
How to identify support and resistance zones
The steps below will help you understand how to identify support and resistance zones effectively. Let’s take the chart below as an example.
Step 1. Identify at least three price action zones. A price action zone can be considered significant on the chart when price follows one of the three patterns below:
1. Price moves sideways after a short rise.
2. Price moves sideways after a short fall.
3. Price reverses sharply at a specific level.
Below are example charts for these three cases:
In the chart below, the circled points show price tending to stall after a short rise:
In the chart below, the circled points show price tending to stop falling after a short decline
In the chart below, the circled points show sharp price reversals:
Step 2. Connect the price action zones with a horizontal line that passes through as many of them as possible. Depending on where this line sits relative to the current market price, we can treat it as a support or resistance level.
For example, the circled price action zones all lie within the 425–430 range, while the stock’s current price is 442.5, above that range, so the 425–430 zone can be treated as support.
An important point when identifying these price action zones is to make sure they are far enough apart in time. The further apart two price action zones are, the stronger the support or resistance. Moreover, the more price action zones that occur within the same price range, the more reliable they are.
Here is another example: you can identify the support and resistance zones of stock X using the same rules. Resistance is at roughly 210–215, and support at 195–202.
If X’s price starts to rise, it is likely to meet resistance at 214. This means that at 214, more selling may appear and turn price lower. But the question is: what guarantees that more selling will appear at 214? In other words, is the resistance zone reliable?
Based on historical data, we can see that whenever X reached 214, it reacted in a particular way that created a price action zone. Since these price action zones are also far enough apart, we can treat 214 as a time-tested price action zone. So, based on the first principle of technical analysis – “history tends to repeat itself” – we can consider these support and resistance levels reliable. Well-defined support and resistance zones are usually very “firm” and give buy/sell signals with a high success rate.
One final point to stress: no trading method is 100% accurate. However, we can increase our success rate by understanding as many technical tools as possible and combining them sensibly.
To link back to the previous article: what happens if a Bullish Engulfing pattern appears at a support zone? We get double confirmation for a buy:
- A Bullish Engulfing candlestick pattern gives a bullish reversal signal, suggesting a good buy point.
- The support level suggests to traders that there may be significant buying at this price zone.
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Happy trading !
