Success in stock trading is heavily determined by how well you navigate the daily fluctuations in supply and demand. Volume and Price, which are the basis of most technical indicators, will always leave footprints. These footprints are embedded in the chart as price action patterns.
Price action constitutes all the patterns we see in a given time frame. By analyzing price action, we are able to position ourselves at low risk levels so that we can score a profit. The basis of this positioning is hinged on the analysis of Support and Resistance.
Defining Support and Resistance
Support and Resistance show where the strength and weakness of supply and demand are in the chart. It allows you to see the highest concentration of buying and selling so that you can make more accurate trade analysis.
Support
A support level is formed when a falling stock price is met with a huge demand in buying. This spike in buying shifts the trajectory of the price upwards. It will continue to go up as long as the volume of buying is sustained. The point in the chart where the price bounced will now act as its support.
A Support level is plotted as a line connecting previous lows of an uptrend.
Resistance
A resistance level is formed when a rising stock price is met with a strong volume in selling. At a given price, sellers start to dispose of shares and completely overwhelm the buyers. This surge in selling halts the rally and shifts the price back to previous levels. The point in the chart where the price rally is rejected will now act as its resistance.
A Resistance level is plotted as a line connecting previous highs of a downtrend.
Note that there are always multiple support and resistance levels in a chart. The more instances a price "touches" a support or resistance, the stronger that level is. It is advised that you look at different time frames and plot the support and resistance levels to get a more accurate analysis.
The Golden Rule
Buy at Support. Sell at Resistance.
The golden rule of Technical Analysis is to buy at Support and Sell at Resistance. This is the fundamental platform by which a trader can make a profit in the market. The art of plotting these lines will add a market timing component to the trade plan. If plotted correctly in a price chart, Support and Resistance will allow a trader to see the highest concentration of institutional buying and selling.
Types of Support and Resistance
1. Static Support and Resistance
Static support and resistances are plotted by connecting previous highs and lows in a price chart. They can be used in the context of a specific trend or simply by plotting bounce points and price rejections in a given time frame.
a. Trend Line Support and Resistance
Trend Line supports and resistances are diagonal lines that connects the peaks and troughs of trend channels. This helps a trader analyze if a stock price is respecting a trend or if a reversal is forming.
The chart above shows an uptrend channel with clearly defined trend lines. You can observe how the price creates higher highs and higher lows as it swings to and from the support and resistance levels. Swing traders can position every time the price bounces at the trend line support and sell as soon as it hits the trend line resistance.
The chart above shows an extended downtrend channel. Notice how the price moves lower as it creates lower highs and lower lows. The selling subsides at 6 php and forms a basing formation that eventually breaks the downtrend channel and shifts the price to a breakout rally.
b. Horizontal Support and Resistance
Horizontal Supports and Resistances connect the peaks and troughs of a stock price. It shows you the potential support levels where you can catch the price and the resistance levels wherein you can sell it at a profit.
The chart above shows clear horizontal support levels where the price can potentially bounce to. Previous resistances that have been broken will now act as support levels for the price. The reason behind this is that it takes substantial buying pressure to be able to overcome key resistance levels. The amount of buyers who have bought at the breakout level will now act as your initial support area.
The chart above show a badly beaten stock who has encountered heavy selling. This chart has numerous support levels that are now acting as resistance areas. Heavy selling pressure is needed to be able to overpower previous supports levels. As such, people will likely take profit should the price swing up to these price levels again.
2. Dynamic Support and Resistance
Dynamic Supports and Resistances are often derived from Moving Average lines. These lines are used in conjunction with other indicators to show specific signals to determine more accurate entries and exits in a stock price.
Moving Averages are simply dynamic technical indicators that help smooth out the price data over a specified period of time by creating a constantly updated average price.
There are 4 major Moving Averages used in Technical Analysis:
Moving Average (MA) 20 (shown in the charts below as the RED line): Calculated average of the past 20 days
Moving Average (MA) 50 (shown in the charts below as the PURPLE line): Calculated average of the past 50 days
Moving Average (MA) 100 (shown in the charts below as the BLUE line): Calculated average of the past 100 days
Moving Average (MA) 200 (shown in the charts below as the YELLOW line): Calculated average of the past 200 days
The chart above shows the 2008 financial crisis as seen in the Philippines Stock Exchange Index (PSEI). The advent of the market crash is illustrated by how the 4 Moving Averages shifted above the price thereby acting as its dynamic resistance. This signals heavy institutional selling which drags the price lower each day.
As the price continued to fall, you can observe how the MAs act as resistances that reject the price with every breakout retest. The prices will continue to go down until institutional buying picks up so that it may push the price above the dynamic resistances.
The chart above shows the major bull market rally of the Philippines Stock Exchange Index (PSEI) after it has recovered from the 2008 financial crisis. The recovery period shows a convergence of the 4 major Moving Averages shifting below the price thereby acting as its dynamic support.
Bull markets generally start when the MA200 line starts supporting the price for consecutive number of months. This signals the start of more aggressive institutional buying.
In Summary
Being aligned to the volume of institutional buying and selling is key to proper market timing. To be able to determine this, we use Supports and Resistances to gauge where the highest volume of buying and selling will likely take place in the chart.
Plotting Supports and Resistances provide a trader with an initial template of where to buy and where to sell. When the levels for entries and exits are determined, other trade strategy components such as Volume Analysis, Risk Management and Position Sizing can be added. Thus, Support and Resistance are the technical building blocks by which a trader can start crafting a trade plan.
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