Support and resistance are two of the most important concepts in technical analysis. How can investors potentially gain insight by applying support and resistance?
One simple way to think about support and resistance is by imagining a floor and ceiling for stock prices. Imagine spiking a bouncy rubber ball on the floor. What happens when it hits the floor? It stops going down. And when the rubber ball hits the ceiling? It stops going up.
The prices of stocks, indexes, commodities, and other financial instruments sometimes act like a bouncy ball. When price hits a floor, it finds support, stops going down, and starts going up. Conversely, when price hits a ceiling, it encounters resistance, stops going up, and starts moving back down. So how do these support and resistance levels form?
Meet Roger Resistance and Sally Support
Imagine one of the largest fund managers in the world. His name is Roger. Suppose Roger thinks the stock market is overvalued when the S&P 500 ($SPX.X) is at 2100. When the S&P 500 reaches this level, Roger sells billions of dollars of stock.
Another fund manager, Sally, thinks the S&P 500 is undervalued if it falls to 1850. Sally decides to buy billions of dollars of stock anytime the S&P 500 trades down near 1850.
Of course, there are many more market participants than just Roger and Sally, but this is a simple illustration of how support and resistance form. Roger’s selling creates resistance in the S&P 500 at 2100, and Sally’s buying creates support at 1850 (see figure 1).
Sometimes History Rhymes
Could an investor have known the S&P 500 would find support near 1850 in mid-September 2014? Could an investor have predicted the S&P 500 would find resistance at 2100 in December 2014, as seen in figure 2? The answer to both questions is probably not.
Our imaginary fund manager, Sally, didn’t buy until the S&P 500 dropped to 1850. The same goes for Roger, who didn’t start selling until the S&P 500 first reached up to 2100. That’s the trick with support and resistance: investors must first observe support and resistance and then apply it if price returns to those levels. If Sally bought the first time the S&P 500 dropped to 1850, then maybe she’ll buy again if the S&P 500 returns to this level. And Roger might sell again every time the S&P 500 reaches 2100, as seen in figure 3.
Supporting Decisions, Resisting Risks
Once support and resistance levels are defined, what can investors do with this information? There are generally three ways to apply support and resistance. The first is by using these levels to help determine trends.
In the S&P 500 example we’re working with, the trend was sideways for well over a year. When the S&P 500 moves above resistance or below support, the sideways trend will break, and the market may potentially trend in the direction of the break. This information alone can be valuable and help guide investing decisions.
Additionally, investors might potentially see a buy signal if the S&P 500 moves above resistance. Think back to the fund manager, Roger: eventually, he might sell all his stocks. With Roger’s selling complete, the S&P 500 might move higher.
Conversely, investors might potentially see a sell signal if the S&P 500 moves below support. The fund manager Sally might buy all she needs, and when her buying is complete, the S&P 500 might move lower.
A final way to apply support and resistance is to use these levels to help filter potential buy and sell signals. For example, suppose the S&P 500 moves up to resistance at 2100, as it’s done twice over the last several months. At 2100, were these good times to buy? Conversely, when the S&P 500 dropped to support near 1850, were these good times to sell?
As a word of caution, remember that technical analysis is just one form of analysis. It’s risky to base investing decisions on one form of analysis alone. Consider combining other forms, such as fundamental and economic analysis, with technical analysis concepts like support and resistance.
Practice Technical Analysis
Log on to your account at tdameritrade.com and enter $SPX.X in the symbol box. Click Draw trendlines to practice applying support and resistance.