SUPPORT & RESISTANCE

Support and Resistance

Think of security prices as the result of a head-to-head battle between a bull (the buyer) and a bear (the seller). The bulls push prices higher and the bears push prices lower. The direction prices actually move reveals who is winning the battle.

Using this analogy, consider the price action of Phillip Morris in Figure 6. During the period shown, note how each time prices fell to the $45.50 level, the bulls (i.e., the buyers) took control and prevented prices from falling further. That means that at the price of $45.50, buyers felt that investing in Phillip Morris was worthwhile (and sellers were not willing to sell for less than $45.50). This type of price action is referred to as support, because buyers are supporting the price of $45.50.

Figure 6

Similar to support, a "resistance" level is the point at which sellers take control of prices and prevent them from rising higher. Consider Figure 7. Note how each time prices neared the level of $51.50, sellers outnumbered buyers and prevented the price from rising.

Figure 7

The price at which a trade takes place is the price at which a bull and bear agree to do business. It represents the consensus of their expectations. The bulls think prices will move higher and the bears think prices will move lower.

Support levels indicate the price where the majority of investors believe that prices will move higher, and resistance levels indicate the price at which a majority of investors feel prices will move lower.

But investor expectations change with time! For a long time investors did not expect the Dow Industrials to rise above 1,000 (as shown by the heavy resistance at 1,000 in Figure 8). Yet only a few years later, investors were willing to trade with the Dow near 2,500.

Figure 8

When investor expectations change, they often do so abruptly. Note how when prices rose above the resistance level of Hasbro Inc. in Figure 9, they did so decisively. Note too, that the breakout above the resistance level was accompanied with a significant increase in volume.

Figure 9

Once investors accepted that Hasbro could trade above $20.00, more investors were willing to buy it at higher levels (causing both prices and volume to increase). Similarly, sellers who would previously have sold when prices approached $20.00 also began to expect prices to move higher and were no longer willing to sell.

The development of support and resistance levels is probably the most noticeable and reoccurring event on price charts. The penetration of support/resistance levels can be triggered by fundamental changes that are above or below investor expectations (e.g., changes in earnings, management, competition, etc) or by self-fulfilling prophecy ( investors buy as they see prices rise). The cause is not as significant as the effect--new expectations lead to new price levels.

Figure 10 shows a breakout caused by fundamental factors. The breakout occurred when Snapple released a higher than expected earnings report. How do we know it was higher than expectations? By the resulting change in prices following the report!

Figure 10

Other support/resistance levels are more emotional. For example, the DJIA had a tough time changing investor expectations when it neared 3,000 (see Figure 11).

Figure 11

Resistance becomes support

When a resistance level is successfully penetrated, that level becomes a support level. Similarly, when a support level is successfully penetrated, that level becomes a resistance level.

An example of resistance changing to support is shown in Figure 17. When prices broke above the resistance level of $45.00, the level of $45.00 became the new support level.

This is because a new "generation" of bulls who didn't buy when prices were less than $45 (they didn't have bullish expectations then) are now anxious to buy anytime prices return near the $45 level.

Figure 17

Similarly, when prices drop below a support level, that level often becomes a resistance level that prices have a difficult time penetrating. When prices approach the previous support level, investors seek to limit their losses by selling (see Figure 18).

Review

I kept discussions of price action, investor expectations, and support/ resistance as concise as possible. However, from my experience working with investors, I am thoroughly convinced that most investors could significantly improve their performance if they would pay more attention to the underlying causes effecting security prices: investor expectations and supply/demand.

The following is a very brief review of the support/resistance concepts discussed in this section.

Figure 18

  1. A security's price represents the fair market value as agreed between buyers (bulls) and sellers (bears).
     
  2. Changes in price are the result of changes in investor expectations of the security's future price.
     
  3. Support levels occur when the consensus is that the price will not move lower. It is the point where buyers outnumber sellers.
     
  4. Resistance levels occur when the consensus is that the price will not move higher. It is the point where sellers outnumber buyers.
     
  5. The penetration of a support or resistance level indicates a change in investor expectations and a shift in the supply/demand lines.
     
  6. Volume is useful in determining how strong the change of expectations really is.
     
  7. Traders' remorse often follows the penetration of a support or resistance level as prices retreat to the penetrated level.