Interpreting Support And Resistance Zones

Technical analysts know the ins and outs of analyzing chart patterns, and a populat technical analysis tool is to use support and resistance zones to identify points on a chart where a pause, or the reversal of a prevailing trend, is likely to occur. Once an area of support or resistance has been identified, it provides valuable potential trade entry or exit points. This is because, as price reaches a point of support or resistance, it will do one of two things: bounce back away from the support or resistance level, or violate the price level and continue in its direction.

Most forms of trades based on these indicators, are based on the belief that support and resistance zones will not be broken. Whether price is halted by the support or resistance level, or breaks through, traders can "bet" on the direction and can quickly determine if they are correct. If price moves in the wrong direction, the position can be closed at a small loss. If price moves in the right direction, however, the move may be substantial. This article will examine key factors in measuring and interpreting support and resistance zones.

What Are Support and Resistance?
Support is a price level where a downtrend can be expected to pause, due to a concentration of demand. As the price of a security drops, demand for the shares increases, thus forming the support line. Resistance zones arise due to a sell-off when prices increase. Understanding this key concept can drastically improve your short-term investing strategy.

So, the basics of support and resistance consist of a support level, which can be thought of as a floor under trading prices, and a resistance level, which can be thought of as the ceiling. Prices fall and test the support level, which will either "hold" and price will bounce back up, or the support level will be violated, and price will drop through the support and likely continue lower, to the next support level.

Frequently, market participants wishing to enter a long trade, will wait for security prices to retrace back to one of these support levels. In other words, buyers are in line, ready to enter positions at these levels and hoping to buy the security at a better, lower price. Figure 1 shows a daily chart of Crocs Inc. (Nasdaq:CROX) that has well established areas of support and resistance.

Figure 1

Resistance is where an uptrend can be expected to pause temporarily, because of a concentration of supply. Using the house analogy, resistance can be thought of as the ceiling. A rubber ball that bounces in a room will hit the floor (support) and then rebound off the ceiling (resistance). A ball that continues to bounce between the floor and the ceiling is similar to a trading instrument that is experiencing price consolidation between support and resistance zones. Now imagine that the ball, in mid-flight, changes to a bowling ball. This extra force, if applied on the way up, will push the ball through the resistance level; on the way down, it will push the ball through the support level. Either way, extra force, or enthusiasm from either the bulls or bears, is needed to break through the support or resistance.

Often, a support level will eventually become a resistance level when price attempts to move back up and, conversely, a resistance level will become a support level, as price temporarily falls back. Traders must take note if there has been a fundamental change of the zones such as long-term expansion or contractions of the intermediate area.

Measuring the Significance of Support and Resistance Zones
Price charts allow traders and investors to visually identify areas of support and resistance, and give clues regarding the significance of these price levels.

Number of touches. The more times price tests a support or resistance area, the more significant the level becomes. When prices keep bouncing off a support or resistance level, more buyers and sellers notice and will base trading decisions on these levels.

Preceding Price Move. Support and resistance zones are likely to be more significant when they are preceded by steep advances or declines. For example, a fast, steep advance (or uptrend) will be met with more competition and enthusiasm, and may be halted by a more significant resistance level than a slow, steady advance. A slow advance may not attract as much attention. This is a good example of how market psychology drives technical indicators.

Volume at Certain Price Levels. The more buying and selling that has occurred at a particular price level, the stronger the support or resistance level is likely to be. This is because traders and investors remember these price levels and are apt to use them again. When strong activity occurs under high volume and the price drops, a lot of selling will likely occur when price returns to that level, since people are far more comfortable closing out a trade at the breakeven point rather than at a loss.

Time. Support and resistance zones become more significant if the levels have been tested regularly, over an extended period of time. Endo Health Solutions (Nasdaq:ENDP), for example, tested a resistance level near $37 for five months, before breaking above it on March 30, 2011. Figure 2 shows a daily chart of ENDP finally pushing above this important resistance level under increasing volume.

Figure 2

Anticipating Support and Resistance Zones
While it is easy to identify areas of support and resistance once they are well established, it is helpful to be able to predict where these zones may occur. Market participants can use a variety of methods to recognize where important support and resistance zones are likely to occur.

Trendlines. One of the easiest ways to identify support and resistance on a price chart is with trendlines. These are straight lines drawn on a chart that connect points where prior price swings (or reversals) have occurred. Trendlines are drawn between swing highs to form a down trendline, or between swing lows to draw an up trendline. The more times price chart touches the trendline, the more significant it becomes as a support or resistance level.

Previous Highs and Lows. Previous highs and lows are prime targets for support and resistance formation. If a stock, for example, is reaching a previous high, it can draw quite a bit of attention as existing long positions may be closed in anticipation of a retracement, and other traders may be ready to buy, if price goes above the previous high.

Retracement Percentages. Many technical analysts rely on retracement percentages to estimate where future support and resistance levels may occur. Retracement percentages use a measurement based on the distance between a major high and low, of a given security. Certain percentages of the move can be applied to the chart to guess the next support of resistance level. Fibonacci retracements are a widely used tool for identifying possible areas where price may halt or reverse.

Moving Averages. Moving averages often act as support and resistance zones, in and of themselves. Figure 3 shows a daily chart of American Express (NYSE:AXP) where price finds support, time and again, on its 200-day moving average. Traders can use moving averages in a variety of ways, such as to anticipate moves to the upside, when price lines cross above a key moving average, or to exit trades, when price drops below a moving average. Regardless of how the moving average is used, they very often create "automatic" support and resistance levels.

Figure 3

The Bottom Line
Support and resistance levels are one of the key concepts used by technical analysts and form the basis of a wide variety of technical analysis tools, including trendlines, and the Fibonacci and the golden ratio. These levels are formed where price has a tendency to halt or reverse and can be used to help identify high probability trade entry and exit points. Practice spotting the support and resistance levels for securities you have an interest in, and you will get better at finding entry and exit points for your trades.