The Concept of Support and Resistance:
In order to identify the target price, we need to recognize the support and resistance points of the same. These are the precise points on the chart that assure a minimum selling or buying of a stock. The support price can be defined as the price that is assumed to attract more buyers to buy the stock rather than sellers. While a resistance price is the price that is assumed to attract more sellers to sell the stock rather than buyers.
We knew about different candlestick patterns in previous two chapters and will know about the support and resistance of the stock. We will also discuss how the target price of a stock is affected by these factors.
What is Support and Resistance of Technical Analysis?
The support and resistance can be considered as a floor and a glass roof that appears to limit the range of market movement. Understanding these concepts will help you develop a strategy of disciplined trading.
The continuous shift in the balance between supply and demand results in dynamic pricing and sometimes a volatile market. When supply exceeds the demand, prices start to fall; whereas when there is not enough supply to meet the demand, prices start to rise.
A technical analyst identifies the trends that are formed in the markets focusing on price levels in the changing balance. However, these levels are formed in the market naturally without any planning; they represent the collective opinion of all market participants. Let us understand the both individually.
In the above chart pattern, we can see the example of support and resistance levels of the stock.
What is Support?
Support Definition: A support level is a price level that works as a floor to stop the further fall of the stock and return to recover the potential (the lower red line on the graph).
What happens is that potential buyers see the price fall and decide it’s a good time to enter the market. This eliminates the oversupply, until supply and demand return to balance and stops the fall. The more buyers decide to join; the balance will tilt the demand, which will cause prices to rise again.
Technical analysts identify the possible levels of support but, provided that markets are never 100% predictable, this cannot be guaranteed. It should be noted that if the price does not exceed the expected level of support, I could go down until you find other support.
What is Resistance?
Resistance Definition: A resistance level is the opposite of a support level. This is the level where price is an increasing reluctance to stop their advance and potentially back down (the upper blue line in the graph).
What happens is that potential sellers are price increases and decide that it’s a good time to sell. This generates more supply in the market, which ultimately downs the level of demand and rebalances the market until it stops rising. The more vendors try to get a higher price; the strength of collective selling will make prices fall.
If the price does not exceed a level of resistance observed, some analysts believe that it is possible to continue to rise until it reaches the next resistance level.
What is Upward Trend?
Upward Trend Definition: In a range of stable operations, the market is relatively stable with a restricted extent of volatility, as defined by the support and resistance levels. However, market conditions will change at some point. If the market conditions improve, this will change the balance between supply and demand.
Here is an example of the sequence of events:
- Suppose a company announces positive earnings estimate.
- Sellers (supply) are not so eager to sell and keep their shares in the hope that the company regains value.
- Buyers will have a greater interest in entering the market.
- The next time the price reaches the previous resistance level; there will be less bearish investors and more bullish investors than before.
- This allows prices to increase above the previous resistance level, and possibly emerge a new trend.
In the above uptrend chart pattern, we can see the example of upward trend of the stock. However, not all bullish and bearish investors have changed their minds. Related news is open to interpretation, and some investors may not even have received.
These investors who have not made a motion at the time of the announcement will consolidate the upward movement of the price on a new trend. Here’s how:
Some bearish investors (who opened the position by selling shares) placed a stop-loss above previous resistance level, to close their positions and limit their losses if the price went up. When the price goes up and activates the stop-loss, the short positions will be closed through the purchase of shares. This drives up demand, collaborating in the tendency to become bullish.
Other buyers, who had previously decided not to participate, may now realize that the lateral trend is broken and want to open positions. This creates more demand and therefore prices raise more.
Conditions for a New Support Level:
Now that the market has risen above the previous resistance level, the new level may become the new support level. They have seen the price rose sharply after reaching the resistance and many will choose to buy if the price returns to this level. The reasons can be reduced to following emotional responses:
Fear of New Level of Support:
The bearish investors (with short positions) having a position just below the resistance level, want to close their position if buying back down to this level. This allows them to have small losses rather than risk the price rises again.
Greed of New Level of Support:
Investors who have previously closed positions and got profits in the resistance level could be identified as the beginning of a new trend, and could decide to re-enter the market. They would like to make it as close as possible to its output level.
Both examples added buying pressure (demand) market and cause prices to rise. Once this new level of support is established, there will be a new level at which buyers will want to buy and collect their benefits. This creates a new level of resilience, resulting in the progressively larger levels of support and resistance. In the next chapter, we will discuss the volumes and will come to know what they actually mean.
- Tutorial Course - Basics of Technical Analysis for Beginners -
» e-Learning Chapter 1: What is Technical Analysis? Definition with Examples.
» e-Learning Chapter 2: Technical Analysis: Types of Technical Chart Patterns.
» e-Learning Chapter 3: What is Candlestick Chart? Definition with Examples.
» e-Learning Chapter 4: Different Types of Single Candlestick Patterns. Definition with Examples.
» e-Learning Chapter 5: Different Types of Multiple Candlestick Patterns. Definition with Examples.
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