Many traders who use technical analysis hear phrases that suggest a "broken support level will become a future area of resistance" or that a "previous level of resistance will become a support." For beginner traders, phrases like this sound like they're spoken in another language, and even many experienced traders never fully understand or appreciate this intriguing role reversal. This article will attempt to shed light on the importance of support and resistance levels and illustrate why traders should take particular note when they reverse roles.
To understand the role reversal between support and resistance, you must first have a basic understanding of these important concepts. Support and resistance are terms used by technical traders to refer to specific price levels that have historically prevented traders from pushing the price of an underlying asset in a certain direction.
For example, let's assume ABC stock has attempted to fall below an ascending trendline several times over the past few months, but although the price approaches this line several times, it fails to move below it. In this case, the trendline is known as a support level because it corresponds to a price level where most investors feel comfortable buying the asset, preventing the market from sending prices drastically lower. On the other hand, traders use resistance to describe when the price of an asset has difficulty moving above a given price level, which then forces the price of the asset to decline.
One of the most interesting phenomena regarding support and resistance occurs when the price of the underlying asset is finally able to break out and go beyond an identified support or resistance level. When this happens, it is not uncommon to see a previous level of support change its role and become a new area of short-term resistance. As you can see from the chart below, the dotted line represents the price that was able to prop up the price movement at points 1 and 2, but this support turns into resistance once the price falls below it, as illustrated by points 3 and 4.
The opposite of this process occurs when the price breaks above resistance. As you can see in the figure below, points 1 and 2 begin as price barriers, but once the bulls are able to push the price above the dotted line, it becomes an area of support (illustrated by points 3 and 4).
Does This Really Happen?
Many traders who learn about the changing roles of support and resistance are often very skeptical and don't believe that the concepts shown in the theoretical figures above actually happen. However, reversals actually occur frequently, even on charts of the biggest names in the stock market such as ExxonMobil, Walmart and even the Dow Jones Industrial Average (DJIA).
Let's look at some real examples that occurred in the markets several years ago. As you can see in the figure below, the bulls were able to keep the DJIA from slipping below the trendline for the first several months of 2006, but this rally came to a decisive end when the index closed below the support of the trendline on May 17, 2006. The break below the trendline was used by traders to suggest that they could expect to see the former support become an area of resistance if the bulls respond by pushing the price higher again. As you can see, the broken trendline became an area of resistance and was a major factor that led to the 5% decline over the following months.
Another interesting example of the role reversal phenomenon can be seen on the chart of oil giant Exon-Mobil (XOM) in the figure below. Notice how the $65 level prevented the share price from moving higher on two separate occasions during the 2005-2006 year. The former $65 resistance becomes support following the break above the $65 line that occurred in mid-July 2006. In this case, technical traders would maintain a bullish outlook on this stock unless they saw XOM fall below the new support of $65, in which case they would watch for the former support to become an area of resistance again.
The final example of Walmart Inc. (WMT) is similar to the XOM chart, because these two charts illustrate that a support/resistance level can change its role on some of the most highly followed companies on the stock market. In the example below, you can see that the $51 level prevented the bears from pushing the price of Walmart shares lower for most of 2004, but this level quickly became resistance once the bears sent the shares below it in early 2005. Many technical traders continued to pay close attention to Walmart when the price of the shares approached the $51 level for the majority of 2006 because this level has proven to be an influential factor that affects the long-term direction of Walmart's share price.
The Bottom Line
Many technical or other short-term traders learn about support and resistance levels early in their career. Yet, some of these traders never fully learn or understand the intriguing role reversal that occurs once the price of an underlying asset moves beyond one of these critical levels. The concept of reversing roles has its share of critics that don't believe this concept presents itself in the real world, but as shown above, this phenomenon can be found on the charts of some of the most well-known names in the stock market.