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