Support and Resistance lines are such a basic part of traders lives that we sometimes forget new traders can, and do, struggle with drawing these on their charts. We look at a chart, draw it, make note of the levels, and then often base our trades on them.
So let us show you how we do this, and try to lay it out in a simple way.
First off, let me just say that these lines do not need to be exact. They don’t have to be perfect for you to make a good trade. For us, they are used as a basic idea of where the market (the stock you are trading) is going to run into a roadblock.
If the stock is running up, the Resistance Line is where the stock is likely to stop. It doesn’t mean it will immediately start running back down—it’s just a place where the stock will pause, and maybe new input will be needed to push it higher, or to have it turn around and head lower again.
When your stock is dropping, the Support Line is the level that it is likely to run into buying pressure again, and stop the drop. Again, this doesn’t mean it will immediately turn a one-eighty and run back up. It means it’s going to pause there and a change is going to take place. With more buying pressure suddenly there, sellers are going to need to be very confident in whatever inputs had originally caused them to drop this stock, or they are going to need new inputs to push through this level of Support.
Okay, so we’ve decided that the lines do not need to be perfect. They also don’t need to go back in time forever. With modern charting software, you can view almost any time frame, but we typically focus on charts in the 6-12 month time frame. Our feeling is that going back for years doesn’t make sense, as so much could have changed in the company during that time. Look at NFLX today versus NFLX five years ago. Or TSLA. Or whoever. There have been big changes. You can go back further, and you might find more interesting data points back there, but in general, the last year or so is where the action that we are most focused on is at. For indexes and commodities, we will often look at longer-term charts. While the story of an individual company can change completely over several years, a commodity such as wheat is the same wheat today as it was a decade ago. Getting back to individual stocks, let’s take a look at STLD’s one year chart to see how support can become resistance once it is broken.
First, look at that horizontal red line in the $42 area. On the left side of the chart, the price made a small gap above the line and continued to rally to around $48. At that point, it dropped back down to the $42 area and bounced. Notice three times in 2018, whenever the price dropped to the $42 range, it bounced. It is easy to see that the $42 range is a level of support. The more times the price bounces off of a support zone, the more important that level becomes, as traders begin to anticipate a bounce at that level and position their trades accordingly.
Notice something different happened in October. The price touched the $42 range, but instead of bouncing, it dropped through support and dipped below $40 before bouncing back up to $42. Once it hit the $42 range, it dropped again. After dropping to the $38 range, it again attempted to rally and was stopped at the $42 range. This is a classic example of a former support zone becoming a current resistance zone once it has been broken through.
Support and resistance zones take place on charts of commodities and stock indexes as well. A look at the Dow Jones Industrial Average for 2018 shows several instances where previous price reversals served as support or resistance later in the year.
The Dow rallied strongly in January to a high that held all the way until October. After peaking in late January, the price plummeted to its low for the year in early February. Notice that the price then rallied, only to reverse again and work its way down to its February low support level before rallying once again. Any previous sharp price reversal on a chart is a potential level of support or resistance. The reversal shows that at the time it took place, a shift in power between the buyers and sellers took place. Whether that same price level will cause the same reaction at a later date isn’t known in advance. But looking at previous price reversals provides suggestions on where the price may reverse again in the future. As the price approaches support or resistance zones, traders enter positions on the expectation that a support or resistance level will either hold or be broken. If the price is dropping to a support level, the “bulls” (investors who expect the price to rise) will buy, thinking the support level will hold.
Some support and resistance zones are more important than others. For example, breaching a former all-time high or bear market low will attract headline attention in the financial media. Remember the Dot Com bubble? The Nasdaq skyrocketed to an all-time high of 5132 in March of 2001. Once that bubble burst, the price collapsed, and it took over a decade to reach that level again. When it finally did in 2015, the financial media was all abuzz about the Nasdaq finally reaching its 2001 bubble peak. A look at the monthly chart (each candle represents one month) of the Nasdaq shows that the 2001 all-time high served as resistance for sixteen months before the price was finally able to break above it for good. Once the resistance was finally broken, the bears were defeated, and the Nasdaq was free to rally sharply for several months. A minor weekly or monthly reversal, on the other hand, may only cause a brief pause in the price action.
Support and Resistance Recap:
All right, so that’s a brief tutorial. Again, you can see that these things don’t have to be perfect. You draw lines in to give you a good idea where you might run into trouble with your position, or you might find support for it. It’s just a very helpful tool. We don’t consider it an exact science. Knowing in advance where the price is likely to meet resistance or support gives a trader an edge over someone who doesn’t do any technical analysis.
To recap:
- Support Lines occur at lows
- Resistance Lines occur at highs
- Drawing in your lines doesn’t have to be perfect to the penny. There will usually be some wiggle room involved.
- Major reversals, such as all-time-highs/lows, or turns that came at the end of a long trend, are generally stronger.
- Support and Resistance don’t always work, but usually will cause at least a pause in the action.