In this post we will talk about the most simple and useful technical indicator, the lines of support and resistance.
In simple terms, the support and resistance lines are price containment barriers. It’s imperative to comprehend its concept in order to analyze a stock graphically. The concepts of support and resistance are utilized to trace channels of highs and lows, continuation and reversal figures, or simply price barriers, that can be stronger or weaker and that is the objective of our explanation in this post.
Support is the barrier that is below the actual asset price. Therefore, the price must drop in order to find this support.
Resistance is the barrier that is above the actual asset price. Therefore, the price must increase in order to find this resistance.
Support and resistances are names that interchange with one another, because if the price drops and breaks the line of support, automatically the same becomes a line of resistance. Its strength isn’t altered after it is broken, this means that if the price breaks a strong line of support, then that line becomes a strong line of resistance.
The lines of support and resistance are stronger or weaker based on two variables:
- The more horizontal a line is, the stronger the barrier. In other words, if the line of support or resistance is horizontal or almost horizontal, its price is well defined. Therefore, it’s easier to be remembered and harder to be broken, which makes the straight line stronger.
- The more a price touches the line and bounces off of it, the stronger the line is.
Now, here comes the explanation that will make everything written in this post make sense. The straight lines only work because they are based on the memories of the investor. Example:
When you buy or sell an asset, the price at which you closed the deal and the price target that you aim to hit become strongly engraved in your memory. If you bought an asset at a week-high and the price did not go up anymore, forcing you to sell it for a loss, you will no longer buy it at that price level.
In the same way, when you buy an asset close to the week-low and the prices go up right after, giving you a nice profit, you will remember that price as a good buy price and if your asset drops back to that same price level, you will most likely re-purchase hoping to have the same returns.
This effect, caused by the memory of investors, gives more strength to certain price levels, turning these levels into psychological barriers which we call Support and Resistance. In a strong support zone, which means it was tested many times and is represented by a horizontal straight line, it is expected that the price interrupts a drop and bounces back up, creating buying opportunities for the investors. The opposite happens with resistance lines.
When paying attention, it is easy to notice buying and selling opportunities that are caused by the same investors, so it’s important to invest attentively to what the mass of investors are doing because support and resistances are not magical lines of a trend reversal, they tend to be broken sooner or later, and you must be ready for this by placing Stops in your trades.
Below is an example of support and resistance lines. The resistance is traced in green, in the value of 66.528 points, above the actual price of 57.463 points, and the support is traced in red at 44.937 points, below the actual price mentioned above.
The green resistance line is thicker than the red support line to illustrate what was described above. It’s noticeable that only one bar touches the support line, in truth it is the bar that created it, while there are two bars touching the line of resistance and other bars closer to the resistance rather than the support.
This shows the correlation of strength created in this graph, it’s easier to break the support than the resistance, remembering that the price should drop to the support zone first, which doesn’t seem to be the case at the moment.
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