Thursday, January 5, 2012

Support and Resistance

We often hear analysts talking about the support and resistance levels of stocks, but what are they? An easy way to look at it is that we imagine a support is like a temporary floor, whereas resistance is like a temporary ceiling.

To understand the concept of support better, just think of a ball bouncing on the floor. Each time the ball hits the floor, it will bounce back, hit the floor again…and bounce back again. When it hits the floor so hard that it breaks the floor (assuming the floor is fragile) it passes, or surges, right through it. In technical terms, we call it a violation of the support zone. Similarly, as the resistance zone is violated, the stock price will go to a higher level.

This brings us to a very important rule: Once a support zone has been violated, it becomes the resistance zone. Conversely, once a resistance zone is violated, it becomes the support zone of a price.

How to identify the support and resistance level of a security?

There are various ways to identify, today I'll show the 2 most common ways of identifying the support and resistance levels.

1. Trendlines

From the previous lesson, we know that trendlines are formed with successive peaks and lows joining together. From the chart below, we see the first trendline as the resistance line that the prices couldn't pass through it. The second trenline is interesting - it was the support zone but has been violated a few times and finally it broke down the support and became the resistance zone or line. Trendline 3 has the similar reaction too.

Tips: Draw your trendlines as accurate as possible. Try to connect as many points together as possible. In other words, the trendline must have the most 'touching' of the stock price.

2. Moving Averages

The common moving averages are: 20 days moving average for short term support or resistance level, 50-100 day for medium term support or resistance levels, and 200 day for long term support or resistance level. For a more experience investor, he or she may explore different days moving averages on different stocks. The objective is to find a nice 'fit' on the chart.

For example, in the diagram below, we run a 15 day moving average on the stock and it fits very well into the chart. When we say nice fit, it means every time the stock price hits the 15 day moving average line, it bounces away from it. Hence, this 15 day moving average became the support for the stock between February to May, and similarly, it the line is also acted as the resistance for the stock between May to July.

Tips: Run different days moving averages across the chart to find a best fit of line.

So go to ChartNexus and download the free software for practice!

Happy learning,
Pauline Yong

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