Support/Resistance
Support and resistance
represent key junctures where the forces of supply and demand meet. In the
financial markets, prices are driven by excessive supply (down) and demand (up).
Supply is synonymous with bearish, bears and selling. Demand is synonymous with
bullish, bulls and buying. As demand increases, prices advance and as supply
increases, prices decline. When supply and demand are equal, prices move
sideways as bulls and bears fight it out for control.
Support is the price level at which
demand is thought to be strong enough to prevent the price from declining
further. The logic dictates that as the price declines towards support and gets
cheaper, buyers become more inclined to buy and sellers become less inclined to
sell. By the time the price reaches the support level, it is believed that
demand will overcome supply and prevent the price from falling below support.
One of the most-common and best-known
trading strategies is this: "Buy at the support level and sell at the resistance
level." The significance of the support level can be understood this way:
Imagine that on a given day, for some particular reason (or by sheer chance) a
stock is traded very heavily at a certain price level. Also imagine that many
traders remember this price level because they bought or sold the stock at this
level. Next, suppose that the stock price first moves up away from this level
and, later on, (for some reason or no reason) the stock price trades back again
to the earlier level. Traders who previously bought the stock and sold it for a
profit would likely buy it again at this level. Those who previously sold the
stock at this level and missed the recent run-up would have a chance to buy it
back. Such buying activities usually slow down the drop and may reverse the
momentum. At least, the stock price may take a rest at this level before moving
in a new direction. We can then say that the stock price has hit some "support
level," by which we suppose that it most likely will not quickly drop through
it. The sensible trading strategy is, of course, to buy the stock near this
support level, monitor it closely, and sell it to cut losses if it falls
meaningfully lower than the support level. If the support level does prevent the
stock price from falling and it starts to bounce back, the trader can make a
nice profit that is usually much larger (!) than the amount of loss incurred if
the trade turned south and loss had to be cut.
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