Fortunately, the real-life definitions of support and resistance translate fairly accurately to the world of technical analysis. (Get 10 Tips to Getting Started With Technical Analysis.)
They are simply areas where buyers and sellers have shown a better-than-average willingness to either buy (in the case of support) or sell (in the case of the resistance). They’re simple ideas, but remember that prices are ultimately decided by human emotions.
This trading range may develop over just a couple of months, or sometimes it can take a year or more to develop — it usually depends on the trading range the technician is examining.
Support levels are usually the result of buyers being rewarded for purchasing a stock at a specific price.
I hope that you can think of a time when you bought a stock that immediately rallied. Chances are good that you felt very pleased, and then, after selling that stock for a profit, you were probably more likely to consider buying that stock on dips (or pullbacks) at the same price level. The mentality behind support tends to be, “if it worked once, it will work again.”
When you have enough buyers entering at a certain price, it becomes a support level.
In the chart below, you can see a very clear line of support at the $15 level for Nokia (NOK) for most of 2008, until the stock dipped below that. Then, interestingly, that $15 support level began to act as a site of resistance.
Resistance levels work inversely to support, but just as simply.
Resistance points often occur after a stock makes a prolonged advance after an important news event, such as an optimistic earnings outlook or a successful new product launch.
As the stock rises, early investors sell their holdings as they reap the gains they anticipated, but many investors arrive to the party late and buy in at an already-inflated price. Then they are trapped, as the absence of new buyers leads to the stock’s weakness at the high valuation, and its value begins to fall.
Then, every time the stock subsequently rallies to this level, those latecomers will sell their holdings to try and recoup losses, thus forming a resistance level.
The chart below shows that Wal-Mart (WMT) saw a $55 resistance level for much of 2008, but it then broke through that and found a new resistance level near the $57 mark.
For more help understanding chart patterns and analysis, see Technical Analysis 101.
John Lansing is the editor of Parabolic Options. To learn more about John, read his bio here.