Support and Resistance
Think of prices for financial instruments as a result of a head-to-head
battle between a bull (the buyer) and a bear (the seller). Bulls push
prices higher, and bears lower them. The direction prices actually move
shows who wins the battle.
Support is a level at which bulls (i.e., buyers) take control over the prices and prevent them from falling lower.
Resistance, on the other hand, is the point at which
sellers (bears) take control of prices and prevent them from rising
higher. The price at which a trade takes place is the price at which a
bull and bear agree to do business. It represents the consensus of
their expectations.
Support levels indicate the price where the most of
investors believe that prices will move higher. Resistance levels
indicate the price at which the most of investors feel prices will move
lower.
But investor expectations change with the time, and
they often do so abruptly. The development of support and resistance
levels is probably the most noticeable and reoccurring event on price
charts. The breaking through support/resistance levels can be triggered
by fundamental changes that are above or below investor's expectations
(e.g., changes in earnings, management, competition, etc.) or by self-fulfilling
prophecy (investors buy as they see prices rise). The cause is not so
significant as the effect: new expectations lead to new price levels.
There are support/resistance levels, which are more emotional.
Supply and demand
There is nothing mysterious about support and
resistance: it is classic supply and demand. Remembering ’Econ 101’
class, supply/demand lines show what the supply and demand will be at a
given price.
The supply line shows the quantity (i.e., the number
of shares) that sellers are willing to supply at a given price. When
prices increase, the quantity of sellers also increases as more
investors are willing to sell at these higher prices. The demand line
shows the number of shares that buyers are willing to buy at a given
price. When prices increase, the quantity of buyers decreases as fewer
investors are willing to buy at higher prices.
At any given price, a supply/demand chart shows how many buyers and
sellers there are. In a free market, these lines are continually
changing. Investor's expectations change, and so do the prices buyers
and sellers feel are acceptable. A breakout above a resistance level is
evidence of an upward shift in the demand line as more buyers become
willing to buy at higher prices. Similarly, the failure of a support
level shows that the supply line has shifted downward.
The foundation of most technical analysis tools is
rooted in the concept of supply and demand. Charts of prices for
financial instruments give us a superb view of these forces in action.
Traders’ remorse
After a support/resistance level has been broken through, it is
common for traders to ask temselves about to what extent new prices
represent the facts. For example, after a breakout above a resistance
level, buyers and sellers may both question the validity of the new
price and may decide to sell. This creates a phenomenon that is
referred to as "traders’ remorse": prices return to a
support/resistance level following a price breakout.
The price action following this remorseful period is
crucial. One of two things can happen: either the consensus of
expectations will be that the new price is not warranted, in which case
prices will move back to their previous level; or investors will accept
the new price, in which case prices will continue to move in the
direction of the breaking through.
In case number one, following traders’ remorse, the
consensus of expectations is that a new higher price is not warranted,
a classic "bull trap" (or false breakout) is created. For example, the
prices broke through a certain resistance level (luring in a herd of
bulls who expected prices to move higher), and then prices dropped back
to below the resistance level leaving the bulls holding overpriced
stock. Similar sentiment creates a bear trap. Prices drop below a
support level long enough to get the bears to sell (or sell short) and
then bounce back above the support level leaving the bears out of the
market.
The other thing that can happen following traders’
remorse is that investors expectations may change causing the new price
to be accepted. In this case, prices will continue to move in the
direction of the penetration.
A good way to quantify expectations following a
breakout is with the volume associated with the price breakout. If
prices break through the support/resistance level with a large increase
in volume and the traders’ remorse period is on relatively low volume,
it implies that the new expectations will rule (a minority of investors
are remorseful). Conversely, if the breakout is on moderate volume and
the "remorseful" period is on increased volume, it implies that very
few investor expectations have changed and a return to the original
expectations (i.e., original prices) is warranted.
Resistance becomes support
When a resistance level is successfully broken through, that level
becomes a support level. Similarly, when a support level is
successfully broken through, that level becomes a resistance level.
The reason for it is that a new "generation" of
bulls appears, who refused to buy when prices were low. Now they are
anxious to buy at any time the prices return to the previous level.
Similarly, when prices drop below a support level, that level often
becomes a resistance level that prices have a difficult time breaking
through. When prices approach the previous support level, investors
seek to limit their losses by selling.
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