While investing and trading certainly involve analyzing quantitative data, psychological aspects play just as big (if not bigger) of a role. Traders remember what happened in the past with a stock, and they use that information to forecast what will happen in the future. We see this with support and resistance levels.
A support level refers to a price point where a falling stock will reverse direction. Conversely, resistance is the level at which a stock will cease to increase and begin a downward trend. This chart from Fidelity illustrates these concepts:
Notice how this stock’s price rises until just over 580 (the red line). At that point, it hits resistance and reverses directions.
The opposite happens when the stock is falling. The price declines until it is just over 460 (the green line). At that point, buyers swoop in and purchase the stock, which causes prices to rise again.
This demonstrates the psychological aspect of trading. When a stock is trending in either direction, traders remember these previous turning points. If, for example, the price is falling, they will use chart analysis to find where the “support” lies.
Don’t Try to Catch a Falling Knife
Using the chart above, imagine if you were trading around Apr-13. You want to buy this stock, but you also don’t want to get caught in a downward trend. This feeling is often captured by the saying, “I don’t want to catch a falling knife.” Therefore, you look at the chart to find a good entry point where the price will bottom out. Based on the stock’s history, it appears that that point is just over 460 (green line). According to what the chart shows after Apr-13, you would have made a good decision.
If support levels help you determine when to buy, resistance levels help you decide when to sell or when to wait before purchasing. Sticking with our example, let’s pretend that you bought this stock at the Apr-13 line. Now imagine that after a few months, the stock price enters a consistent uptrend. You begin to wonder if a selloff is coming and whether you should take profits. So, you look for a resistance point. Based on the chart, you decide that around 580, you’ll sell part of your position to lock in some gains.
It’s important to realize that technical analysis (charting) is far from an exact science. Traders will draw support and resistance at different points based on their subjective analysis and knowledge of the stock. When I say “draw,” I mean that literally. Websites like TradingView and StockCharts let you annotate charts for free. You can draw your own trendlines or anything else you want. You can do the same thing on ThinkorSwim’s trading platform.
Support and Resistance Role Reversal
Support and resistance levels are not impenetrable barriers. When a stock’s price breaks through those points, it can be a bullish or bearish sign. For example, if a stock rises above a resistance point, it will often continue to trend upward. Eventually, a new resistance level will be established. Another interesting phenomenon occurs as well: the previous resistance becomes support.
In the chart above, the stock broke through its resistance after Jan-12. The price then continued its upward trajectory until a little after Jul-12. Notice that the previous resistance of 560 became a support level.
The reverse happens when a stock falls below its support (see the following chart). The prior support level becomes a point of resistance.
Moving Averages as Support and Resistance
A stock price’s moving average can also be a helpful way to determine support and resistance. A simple moving average (SMA) calculates the average price of a stock over a specific number of days. For example, to calculate a 50-day simple moving average, you would sum the stock’s daily prices over the last 50 trading days (weekends and holidays are excluded) and divide that total by 50.
It’s called a “moving” average because the calculation is updated every day. Each time a new period occurs, the average moves forward. The oldest price is dropped to make room for the newest one.
You can use moving averages to spot short and long-term trends. For example, a 200-day SMA is considered a long-term metric and a solid support or resistance point. You will often see stock prices bounce off their 200-day SMAs.
This can also occur with short-term trading windows. Check out this chart from Investopedia. It shows how a 15-day SMA can act as support and resistance.
A Cheat Sheet
I realize that not everybody likes the idea of staring at charts to determine support and resistance. If you fall into that category, you’re in luck. The website Barchart does all the work for you with their helpful — and free — “Trader’s Cheat Sheet.” Type in any ticker, and Barchart will show you multiple support and resistance levels.
I like to use Barchart’s tool as another set of eyes. I’ll look at daily and weekly charts over various timeframes as well as moving averages. After I determine support and resistance levels from those data points, I’ll check the Cheat Sheet to see what it says.
Remember, identifying support and resistance is not an exact science. Different traders will see different levels. Tools like Barchart’s Cheat Sheet aren’t the “answer key.” They simply help you make your own decisions.
Macro and Sector Support and Resistance Points
Support and resistance levels aren’t limited to individual stocks. You can also use them to detect macro and sector-level trends. For example, if you wanted to determine if technology stocks were ready to break out (or crash), you could analyze the chart for the Technology Select Sector SPDR ETF (XLK).
One of the best sources for this kind of analysis is Sam McCallum’s newsletter, The Weekly Grind. Sam has an uncanny ability to read the markets using logical charts and data, and then communicate his findings in an easy-to-understand, jargon-less manner. I also highly recommend following his Honey Stocks Twitter feed.
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This article is for informational purposes only. It is not financial advice. Please see the full disclaimer for more details.