The principles of support and resistance
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Imagine two horizontal parallel lines, tracking across a chart of asset prices. You may notice how an almost uncanny pattern tends to return, over and over, to retest both floor (support) and ceiling (resistance) levels. Such repetition offers decent value in terms of predicting future moves.
A grasp of the principles behind support and resistance helps clarify the psychological and mechanical underpinnings that validate the entire system of technical analysis.
Basically, a concentration of activity at any price level represents a density of supply and demand, as buyers congregate at support levels, and sellers collect at resistance areas. At some critical juncture, large quantities of a particular asset will have changed hands, often precipitated by external news. People are predisposed not to sell at a loss. If the asset declines, many buyers may get cold feet, and take the next opportunity to get out even, by selling at the ceiling threshold. If, however, it takes off, those who wished they had bought sooner may scoop up more, if and when it retraces back where the excitement started.
An important yet counterintuitive phenomenon is that support and resistance routinely switch their functions, so ceilings become new floors and vice versa. Dave Abate, a technical financial planner with Strategic Wealth Partners, suggests a view of the forces that propel the role reversal. “Support comes into play where an investor’s value proposition determines it is worth their risk to hold a stock in anticipation of their future price targets,” he says.
Resistance kicks in when investors take a dimmer view of whether those targets are reachable. Traders will have put in limit orders, ahead of time, in certain quantities of volume, and at specific levels. Mr Abate explains that an asset then executes “mechanically,” after having been preset according to investors’ original outlooks.
Higher volume at given levels confirms not only increased conviction, but also indicates more traders have an increased emotional commitment.
Recent activity in the FTSE helps illustrate the concept, says Peter Ruud, technical analyst at Informa Global Markets. Noting the highs in June and July, Mr Ruud describes how “resistance levels can turn into support, as an indication that we are moving into a new, higher range”. The FTSE is approaching the 6,000 region for the third time, and generally the third test holds. Mr Ruud looks only for a minor correction, remembering that prices also gravitate toward round numbers. If four times proves a charm, prices should hover near 6,000, before accelerating to the upside.
At Informa, Mr Ruud performs real time analysis, which involves constantly updating support and resistance levels. If the FTSE fails to break the current ceiling, “we will find ourselves back in a range,” he says, “and we might have to go through the whole process again.”