Support and Resistance lines are very important technical tool to a technical analyst or a trader. You, as a trader or technical analyst, should never undermine the significance of these two aspects of the trading plan.
It is imperative that you are clear of these two levels before you enter a trade.
Support and Resistance lines can be your entry and exit levels for a long trade and vice versa for short trade. Moreover, prior knowledge of Support and Resistance brings much needed discipline in trading. Being disciplined is an important step for you to become a successful trader.
When you are aware of these levels, you know when to take profits in case of profitable trade and to exit the loosing trade when your stop-loss gets triggered. These levels are formed as a result of popular notion of Technical Analysis –
” History Repeats Itself “
Let us understand what is a Support and Resistance and how they are important for your trading plan.
Support and Resistance Lines in Technical Analysis
Support is a price level which corresponds to the demand of the security in the market. So it is the price level at which there are lots of buyers to buy that security.
A stock falling to lower levels stops at a price levels which may reflect its fair value at that time and starts rising again. When the stock again falls after rising, it tends to stop at the price level where it stopped previously and buyers start emerging in anticipation of price rise again.
When the buyers outnumber the sellers, price stops falling and either consolidates there or rebounds, thus confirming the Support for that security.
More the number of times stock rebounds from that price level, more strong the Support becomes. These levels remain in the memory of markets, so even if the stock visits that level after months or years have passed, that levels are expected to provide Support to the falling stock.
It is not that every time stock visits that levels, it will bounce back.It may or may not. If the selling pressure is too high like in situations of weak sentiment or panic, these support levels give away and the stock falls to lower price levels after piercing the Support.
Break down from the Support becomes more significant when it happens with high (more than normal average) volumes.
Usually the support line are drawn straight horizontal lines on the charts of the security or stock. A rising Trend line made by joining the lowest points in a particular time period also act as Support and can be taken into consideration while starting a trade.
Resistance is the price levels of the security or a stock which corresponds to the supply of that stock in market. It is opposite to Support.
It is the price level where sellers outnumber the buyers in the market. A stock which is rising, may stop at the Resistance line and retrace back to lower level.
Whenever the stock will rise towards Resistance line, sellers will start emerging, stalling the price rise. More the number of times stock retraces from Resistance, more strong the Resistance.
Whenever the momentum of price rise is strong in the stock and buyer are more aggressive than the sellers, stock will break above the Resistance line after piercing it and enters new territory which becomes new trading level for it. As in case of Support, a falling Trend line made by joining the highest points is also expected to provide good Resistance.
How To Trade Support and Resistance
After you learn to identify support and resistance lines, it is important to learn how to trade support and resistance. These lines give you your target price and stop loss prices.
Importance of Support
If a falling stock takes support at the Support line, traders may consider buying the stock in anticipation of price appreciation. On the other hand, if a stock breaks important Support levels, traders can short sell the stock and go short.
Your tendency should be to buy a stock which is trading above support line. Look to buy it as near to support line as possible. This keeps your stop loss price near the buying price and consequently the risk is small.
Once a support line is pierced on the downside, then you should avoid buying the stock.
Importance of Resistance
A trader who is long in trade should consider taking profit when stock reaches near the Resistance levels. You can also short sell or go short at the Resistance line. Remember, shorting should be done only below Resistance line.
It is worth mentioning that after breakout from the Resistance line, this line becomes the Support for the stock and in case of breakdown from the Support line, this line becomes the new Resistance line for the stock. So it can be traded accordingly by the traders.