Bulls and bears. Supply and demand. These are a couple of the famous give-and-takes that are freely bandied about when the stock market is discussed.
In the world of trend analytics, these terms are representative of something a little more than just cool-sounding buzzwords that may make the market sound accessible to outsiders. Rather, they are part and parcel of a critical stock component called support and resistance.
Support and Resistance Defined
In a way, support and resistance provide the framework for a stock’s overall performance in a given time period. These “lines” run parallel to a charted stock’s peaks and valleys, demonstrating the highs and lows they seldom break through. While they may occasionally peak over or punch below these lines, doing so provides the exception rather than the rule.
This essentially gives the investor a data range that enacts a measure of predictability, in the sense that investors that pick up on such a trend can note when a stock is reaching its peak or its valley. This, then enables them to make informed decisions on stock performance based on technical analysis.
Why Support and Resistance Occurs
Support and resistance may arguably be the most fascinating dynamic at play in the stock market. On paper, there isn’t necessarily a reason why a stock fluctuates between support and resistance – it appears to just do. But if you dig a little deeper, you’ll see it has nothing to do with apparent magic.
The main cause of support and resistance traces directly back to supply and demand, or more to the point, the psychology behind the practice. When a visible pattern emerges on a stock, traders buy and sell within the parameters of support and resistance without an issue, until the established trendlines threaten to be breeched. Once these are reached, the psychology of the market associated with the laws of supply and demand simply cause a bit of a hive mind amongst investors; one in which the collective mindset shifts widely enough to reverse trends.
The prime mover behind the psychological tenants that establish support and resistance tend to build upon a foundation of round numbers. Whether the number is 10 or 1,000, numbers that end in zero oftentimes are representative of major psychological turning points within an investor’s mental state. These turning points are also the spots where investors will pull the trigger on various buy or sell decisions.
The transactions that are built up by round numbers tend to cause stagnation on a stock. For example, if a down trending stock begins to fall toward a significantly looking round number like $50, buyers will tend to snap up large amount of the stock. Conversely, sellers have a tendency to start selling off a stock once it starts climbing to a peak based on a round number. Because of this phenomenon, the proliferation of selling and buying pressures associated with these digits make them prime targets for points of support and resistance to develop on a stock.
Breaking Through to the Other Side
It’s important to note that even though it may appear as if a stock may float in between the lines of support and resistance in perpetuity, that doesn’t mean that stock is stuck in the pattern forever. In reality, a stock could break free of the psychological laws of supply and demand and break through a line of support or resistance and continue to trend upward. This is called role reversal in stock market parlance, and it’s a bit of a game changer.
Once a stock breaks through a support or a resistance line, the status of the “line” that’s broken through switches. If it breaks through the resistance line, that line flips to being the support line. If it breaks through the support line, that line flips to being the resistance line. The impetus behind such changes tie back to a shift in a change related to the stock’s supply and demand.
There is one caveat to this flip. In order to be considered a true role reversal, the stock has to hang around the other side of the line it breaks through for a strong, sustained period. A stock that merely blips past the line for a short spell does not count here. It’s wise on the part of the investor to make sure they are basing their strategy on what ends up being an anomaly.
Why is Support and Resistance Important?
Savvy investors that deploy technical analysis can use support and resistance as critical tools to increase the predictability of a stock’s performance, and therefore, eliminate a chunk of market-related guesswork. If an investor spots a line on the chart where the stock never seems to break through with any consistency, they can make shrewd buying or selling decisions based on the peaks and valleys in a manner to maximize profits without second-guessing whether or not they should have stayed in the game longer. One of the decisions that can be made here is placing orders before the peak number is hit. Due to the volatility that tends to happen around the top and bottom numbers, it’s routine for a stock to get close to either line, but not actually hit the line. Those that place orders at the peak or the valley may come up short more often than not.
It also can be a great way for technical analysts to spot ongoing trends. If a share price hangs between the levels of support and resistance, investors using technical analysis will take it as a sign that whatever trend the stock is exhibiting will continue. This, too, can help shape their strategy immensely.
Perhaps most importantly, the principle of support and resistance brings a certain level of stability to the fast-paced world of technical analysis. Being able to frame a stock’s performance can help technical analysts scrutinize a stock on a more intimate, focused level; one that strips various forms of chart-based distraction from the proceedings. It ultimately produces a strategy that’s mean and lean, and this could be something a technical analyst could deeply appreciate.