What is Support and Resistance
In
technical analysis the lows and highs of the trend are identified by
their appropriate names, which are support and resistance levels
respectively. These levels are the areas where most traders are willing
either to buy or sell an asset.
Support level indicates the area
where the buying interest is high and exceeds the selling pressure. At
this level the price is considered very attractive for taking long
positions and most traders choose to buy an asset when the price
approaches a support level.
Resistance level represents the area
where the selling interest is high and exceeds the buying pressure.
Traders are willing to take short positions and sell an asset when the
price approaches this area.
How to Draw Support and Resistance Lines
Support
and resistance levels form an essential part of technical analysis used
to identify the trend and make trading decisions. They test, as well as
confirm trends and should be applied by every trader who uses technical
analysis.
Support level is marked by a line which connects
previous lows. Depending on the primary trend (prevailing direction of
price movements) it can be marked either by a sloping line or a horizontal line.
- In an upward trend the trendline connecting the lows is considered a support with positive slope.
- In a sideways trend the lower trendline is considered a horizontal support.
Resistance
level is marked by a line connecting previous highs. Depending on the
primary trend a resistance level can also be marked either by a sloping
line or a horizontal line.
- In a downward trend the trendline connecting the highs is considered a resistance with negative slope.
- In a sideways trend the upper trendline is considered a horizontal resistance.
For
identifying an uptrend each successive support level should be higher
than the preceding one and each successive resistance level should be
higher than the one preceding it. Otherwise, for instance, when the
support level falls down to the previous low, this indicates that either
the uptrend comes to an end or at least it changes into a sideways
trend.
Conversely, for identifying a downtrend each successive
support level should be lower than the previous one and each successive
resistance should be lower than the previous one. When a support level
comes higher than the previous one, this signals a change in the
existing trend.
An uptrend is inclined to reverse into a
downtrend once the successive higher highs and higher lows change into
successive lower highs and lower lows. And conversely, a downtrend can
reverse into an uptrend when the lower highs and lower lows turn into
successive higher highs and higher lows. In other words, a resistance
level becomes a support level, and a support level becomes a resistance
level.
This kind of reversal at support and resistance levels in
technical analysis is referred to as “rally”, “correction” or “trend
reversal”.
- In case a support level is broken below (plus
certain deviation is possible), investors may assume that the price will
keep on falling. The former support becomes a new resistance level
which is expected to hold rallies.
- In case a resistance level is
broken above (plus certain deviation is possible), investors may assume
that the price will keep on growing. The former resistance becomes a
new support level which is expected to hold declines.
The trend is expected to continue as long as the asset price remains between support and resistance levels.
Support and Resistance Trading Strategy
The
rationale of support level is that as the price gets closer to this
area, buyers see a better deal and are willing to buy, while sellers see
a worse deal and are less likely to sell. However, support cannot
always hold prices. And when prices break below the support level this
indicates that sellers may have a good opportunity to sell the asset.
On
the other hand, the main premise behind resistance is that as the price
gets closer to the resistance level sellers get more willing to sell
an asset, while buyers will be less inclined to buy. A break above the
resistance level indicates an increased willingness to buy.
A
reversal between support and resistance levels can be either a positive
or a negative change against the prevailing trend. It is crucial for
analysts and market participants, because depending on the signals of
these patterns they adopt a trading strategy on the same security.
