“The stock is near a support level.” “This stock is at a resistance level.” You’ve probably encountered these words by stock market analysts on websites or on TV. This lesson is intended shed light on the concept of support and resistance and how to take advantage of it for successful trading.
Now, before you can understand about support and resistance, it is important to know how demand and supply affect the price of stocks.
Demand and Supply: The Driving Force behind Stock Prices
The price of any stock is driven by supply as well as demand. Whenever there is excessive supply, it is a sign of selling and consequently, bearishness. Whenever there is excessive demand, buying happens and is an indication of bullishness. Whenever the demand and supply are almost equal and therefore, seems to be at an impasse, the price starts to move sideways and the bulls and bears wrestle for control.
In a nutshell,
- Higher Demand => Price Increases => Bullishness
- Higher Supply => Price Decreases => Bearishness
- Demand = Supply => Price moves sideways => Bulls and Bears battle for control
Now that you understand about demand and supply, it is easier to comprehend what a support and resistance are.
Support – The High Demand Area
Support basically refers to the level of the price of a stock at which there is a strong demand. The strength of this demand basically prevents the stock price from moving further downwards.
The support level of a stock is generally referred to as a zone. This support zone (or support level) would be below the current price of the stock. Whenever the stock price moves down, this support level acts as a good point for the price to bounce back.
Now, if the stock price breaks down below a support level, it shows that the sellers have decided to sell the stock at a lower price. After this breakdown, the bears would take control from the bulls. Buyers would also stay away from buying at this support level and would wait until a new lower level of support gets established for the stock. The figure below illustrates the support level.
Resistance – The High Supply Area
Resistance basically refers to the price levels wherein the sellers are very strong. Therefore, there is a high supply of stock available in the resistance area. Hence, the price would be prevented from raising higher than this level.
The resistance of a stock is generally referred to as a resistance zone. This resistance zone (or resistance level) would be above the current price of the stock.
Whenever the stock crosses above the resistance level and continues the upmove, the trend would change from bearish to a bullish bias. Such a breakout from resistance indicates buyer strength.
The figure below illustrates the resistance level.
Now that you have understood what is a support and resistance, let’s take it up a notch.
Resistance-Turned-Support and Support-Turned-Resistance
Many times, a previous support level can turn as a resistance level once the stock breaks down from the support level. Similarly, a previous resistance level, once crossed, would start to act as a new support level. One such example is as shown in the figure below.
So, how exactly do you use these support-resistance level for trading? The answer is quite logical if you think about it.
Trading Using Support and Resistance
The ideal buy and sell points of a stock can be identified using support/ resistance levels.
The ideal point to buy a stock (take a long position) is when
- The stock has taken support at a support level
- The stock has crossed a resistance level (and it became a resistance-turned-support level) and pulled back to that level again.
The ideal point to sell a stock (take short position) is when
- The stock has taken resistance at a resistance level
- The stock has crossed below a support level (and it became a support-turned-resistance level) and is attempting to cross it again.
The figure below shows some ideal entry and exit points of trading a stock using support and resistance levels.
Note: In addition to these, there are multiple other support and resistance that are used by expert traders like gap down/ gap up and wide range candles. Typically, traders use support and resistance levels in conjunction with other indicators, overall trend, and volume analysis to make a decision on entry and exit points.