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Chapter 4 Support and Resistance

The concept of Support and Resistance

Support and resistance represent key junctures where the forces of demand and supply meet. Just as a ball bounces when it hits the floor or drops after being thrown to the ceiling, support and resistance define natural boundaries for rising and falling prices.

  • Supply is synonymous with bearish, bears and selling.

  • Demand is synonymous with bullish, bulls and buying.

As demand increases, prices move up and when supply increases, prices decline. When supply and demand are equal, prices move sideways.

Support

Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. By the time the price reaches the support level, it is believed that demand will be stronger than supply and prevent the price from falling below support. As the price declines towards support, buyers become more inclined to buy and sellers become less inclined to sell.

Resistance

Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. As the price reaches the resistance level, it is assumed that supply will be stronger, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will be stronger than demand and prevent the price from crossing the resistance.

Determining the strength of Support and Resistance levels

The strength or weakness determines how much buying or selling interest will be required to break the level. The length of time that a support or resistance level exists determines the strength or weakness of that level. Also, the greater volume traded at any level, the stronger that level will be.

Please note

  • Support becomes Resistance and Resistance becomes Support on a breakdown / breakout of a Trend-line.

  • Old Support becomes new Resistance and old Resistance becomes new Support.

Reason for Support and Resistance to Exist

Support and Resistance exist because people/traders have memories. Each price point has certain memories associated with it. Please refer to the diagram below and check for the price point marked by the red arrow. Investors got trapped and remember this price point as a sheer pain and wait patiently to exit once the price point is reached in future. The price point marked by the green arrow is a sigh of relief for those investors who got trapped at the red arrow point earlier. Desperation shown by the previous buyers drags the price down in short term. Hence, the price level acts as a resistance for near future.

Break-down

It is the phenomenon where the prices move downwards breaking an important Support level in the process. Normally, a breakdown is supported by high volumes and it indicates a further downtrend in that stock.

Break-out

It is the phenomenon where the prices move upwards out of range breaking an important Resistance level in the process. Normally, a breakout is supported by high volumes and it indicates a further up move in the stock.

Key Takeaways

  • Support or Resistance represents a concentration of demand and supply sufficient to halt a price move, at least temporarily.

  • Potential Support/Resistance zones develop at previous high and lows, and close to Trend lines and moving averages, emotional points on a chart and Fibonacci retracements.

  • The strength or weakness of Support /Resistance zones is determined by how much buying or selling interest will be required to break the level. With respect to the length of time for which a Support or Resistance level exists, the greater volume traded at any level, the stronger that level will be.

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