It is the level of price at which the demand is likely to be high for preventing the price from falling any more. The reasoning is, when the price goes down, the pressure for a particular share will increase. When the price reaches a certain level known as the support level, the demand for the stock will likely be more than supply, preventing the price from falling below this support level.

Opposite the ‘support’ level is the ‘Resistance’. It is the level of price at which the selling that is strong enough to prevent the price from going up anymore. The reasoning is that when the price increase, the sellers tend to sell, and the tendency to buy gets reduced. When the prices reach a particular level known as the resistance level, the availability (supply) of the share is likely to be higher than the demand preventing the price from going above the resistance level.

Dr. Alex Elder in his book “Trading for a Living,” illustrates ‘support’ and ‘resistance’ using the example of a bouncing ball – “A ball hits the floor and bounces. It drops after it hits the ceiling. Support and resistance are like a floor and a ceiling, with prices, sandwiched between them.” When the price of a stock has come down to a level where its demand increases, investors start to buy. It creates a “floor”, which we call the support level. The price of the stock increases to a level where its demand goes down, and holders start selling for booking profits, creating a “ceiling” or the resistance level.

RECOGNIZING SUPPORT AND RESISTANCE.

The support and resistance levels are recognized by analyzing a chart. (See example) Search for the low points where a stock has fallen to this level and has not gone down anymore. It is called the support level. When a stock price goes up to a certain high level and does not go up anymore, it is called the resistance level.

When a stock bounces from the support level and drops back from resistance more number of times, it makes these support and resistance levels stronger. When this happens more often, the likely hood of this happening again is more. When these historical patterns repeat more times, traders get to understand and become more confident in forecasting the behavior of the stock in the future.

ROUND NUMBERS

Round numbers are a type of universal support and resistance seen across quite several securities. Numbers like 10, 20, 25, 50, 65, 500, 1,000, etc., are seen to be important in support and resistance levels. These numbers represent a crucial turning point psychologically. It is a point at which most traders tend to take buy and sell decisions.

Investors often purchase a large number of shares when the price starts to drop to a round number, for example, Rs 50. It is difficult for shares price to drop below the level. In the same way, they start selling stock as it rises toward a round number. Here it is difficult for the shares to rise above this upper level. The increase in buying and selling at these levels makes them important points of support and resistance. In many cases, this also acts as a crucial psychological point.

THE IMPORTANCE OF SUPPORT AND RESISTANCE

The analysis of Support and Resistance is a vital part of the trends for making trading decisions.

It can also identify the start of the trend reversal.

Let us say that a trader has identified a crucial resistance level that has not changed, although it has stood the test several times. The investor may decide to book profits as the price of the share has moved towards the point from where it is not likely to move up any further.

THE PSYCHOLOGY BEHIND SUPPORT AND RESISTANCE

The theory of support and resistance is understood better if we categorize market participants as follows.

1) Traders who have a ‘BUY’ position who would profit if the prices were to increase.

2) Traders who have a ‘SELL’ position who would profit if the prices were to decrease.

3) Traders who prematurely closed their previous positions.

4) Traders who are not sure on which side of the market to enter the market and are looking for the right entry points.

Those who have bought shares assuming that prices start moving forward from the support level would regret they did not buy more. So, whenever the prices are back to the support level, they would add more.

Those traders who have done short selling would have realized that their assumption was wrong and expect the prices to come down to the support level where they entered so that they can exit without losing.

It could also be that traders who had exited their long positions at the support level would regret that they came out too early and maybe waiting for a chance to get back into the position again around the support level.

Those traders who were undecided earlier are likely to decide to enter the market and purchase after seeing the prices advance. They will look for a good buying opportunity and enter the market when the price is at or around the support level.

All traders will have the same intention to buy and wait for an opportunity when the prices drop to the support level. Buying would take place by all four groups at the support level resulting in the prices going up.

ROLE REVERSAL

As soon as the resistance or support level is cut, their roles are changed. If the price were to go down below the support level, then this level is likely to become resistance. On the other hand, if the price goes above the resistance level, it could become a support level. When the price moves beyond a level of support or resistance, assuming that the supply and demand situation has changed.

The broken support or resistance, then change their roles. For this to happen, the price must move either through the support or resistance levels.