After learning about trends, the next major concept you need to learn is that of support and resistance. You'll often hear analysts talking about a certain security approaching a resistance or support. These are simply price levels or a range of prices that a security or currency doesn't often go over (resistance) or go under (support).
Figure 1 depicts a simple example of a resistance level and support level. You can see in the chart the support is the level at which the price seldom falls below and the resistance is the level the price seldom exceeds. Each time the price hits the resistance or support, the price appears to hit a wall and reverses, at least in the short term.
Double Tops And Double Bottoms
Why Does it Happen?
The primary reasons why prices behave in this fashion is because of supply and demand and market psychology. At support levels the number of buyers generally exceeds the number of sellers and pushes the price back up, and at resistance levels the number of sellers exceeds the number of buyers causing the price to go back down. This could occur frequently in a range until new material information is available that shifts the price to a new range, in which case a new support and resistance level would be established.
Once a resistance or support level is breached, the roles of the resistance and support flip. If the price surges below a support level, that same support level will then become the new resistance level. Conversely, if the price surges above a resistance level, that same resistance will tend to become the new support level. This role reversal will generally only occur once a strong price moved has shifted the price to a new range - often caused by major news or economic reports. As an example take a look at Figure 2. Initially, the dotted line represented a resistance level but once the price broke through the resistance into a new range, the old resistance level became the new support level. (Learn the difference between a reversal and retracement in Retracement Or Reversal: Know The Difference.)
Sometimes with stocks, a support or resistance level will be a round number such as 50, 100, or 1,000 that represents a psychological barrier to further increases or decreases in the price. But in forex as well as stocks, keep in mind that a support or resistance level can vary, and is often not an exact number. You should view support and resistance levels as zones rather than a specific number.
Resistance and Support Levels
The Importance of Support and Resistance
Support and resistance analysis is an important part of trends because it can be used to help make trading decisions and identify when a trend may be reversing. These levels can sometimes help a trader identify when to take profits. For example if a certain price levels is reached, the trader might want to take profits because he knows the price level seldom rises past a particular resistance level. Or alternatively if the trader identifies a support level the price seldom falls below, he could use that information to help him decide on an entry point to his position. (To learn more about using resistance and support levels in trading, refer to our article Trading on Support.)
Support and resistance levels are tools every trader that uses technical analysis should use and monitor. In the next section, we'll take a look at another common chart pattern that can help you identify upcoming price movement - the double top and double bottom.