DIY Guide to Technical Analysis: Support and Resistance

One way to look at technical analysis is that it’s a study in supply and demand. Technicians use the concepts of supply and demand to explain why trends occur and how human behavior shapes stock price movement. Don’t worry, you won’t be analyzing supply and demand curves or studying Coase theorem; you’ll just be looking for highs and lows. 

So, what is supply and demand for stocks? Supply is the number of shares available for purchase at a certain price. Demand is the number of orders for shares at a certain price. There are many factors that affect supply and demand, such as a company’s earnings and earnings potential, the strength of the overall economy, and alternative investment returns. But a technical analyst doesn’t worry about these fundamental factors; instead, they attempt to track changes in supply and demand and make decisions accordingly.

Changes in supply and demand drive stock prices up and down. Generally, when more investors are eager to buy (or demand is high), prices rise to entice more people to sell and increase supply. And when more investors are eager to sell (or supply is high), prices fall to entice more people to buy and increase demand.

Figure 1 shows what this looks like in terms of the highs and lows of an uptrend. High demand drives the price of the stock toward a high—this is known as a rally. The stock starts to peak as supply and demand meet equilibrium. Then, as supply surpasses demand, price pulls back or falls. This is also known as a retracement. When supply and demand meet equilibrium again, the stock establishes a new higher low, then rallies to a higher high on strong demand.

One reason stocks make higher highs and higher lows is because of institutional money. Institutions are large money managers like mutual fund companies, pension funds, investment banks, insurance companies, etc. When institutions take a position in a company, they invest thousands, if not millions, of dollars. If they were to dump that much volume or demand on to the market at one time, the stock price would skyrocket to find enough supply to meet all the orders. Once the sellers fill the orders, the price would likely return to somewhere near the initial price, resulting in huge losses for the institutions.

Therefore, institutions are methodical in the way they accumulate shares. They commonly buy a little at a time for a few days, knowing their actions will drive the stock price higher. Then they wait for the stock to pull back. After the stock has pulled back, they buy more shares at this lower and more desirable price, causing the price to rise again. They then stop buying, allow the stock to pull back, and start the buying cycle again. This is why during an uptrend you often see higher volume during rallies and lower volume during retracements. The opposite is often true for downtrends—higher volume during sell-offs and lower volume during rallies. 

Support and Resistance Levels

There are levels of supply and demand known as support and resistance. Because of the story they tell about price, support and resistance are significant actionable levels—places where investors often buy and sell. Let’s discuss how to define these levels.

Lows are known as support levels. As you’ve learned, these are areas where demand starts to increase and where investors are more willing to buy (see figure 2).

Support works like a floor—it “supports” the price from going lower. However, support isn’t usually one specific price but a relatively small range.

Highs are known as resistance levels. These are areas where supply starts to increase and where investors are more willing to sell (see figure 3).

Resistance is a ceiling—it “resists” the price from going higher. Price reaches this level, stops, and turns down. Like support, resistance isn’t usually one specific price either. And the more highs at a certain level, the stronger the resistance level is.

Investors use support and resistance levels to identify the direction of the trend and project future price movement. Let’s look at each of these uses.

First, investors use support and resistance to identify the direction of a trend. They connect lows and highs with diagonal support and resistance lines—these act as trendlines. Investors generally draw support on uptrending stocks and resistance on downtrending stocks to make the trend more visible. 

To create a trendline at support, draw a line connecting as many lows as possible. When support and resistance lines are parallel, they create a price channel. Short-term traders use price channels for swing trading.

Investors also project future price movement by drawing horizontal support and resistance levels. An area of resistance from months ago can act as support later, just as old support can act as new resistance (see figure 4).

Conclusion

Analyzing supply and demand is essential to technicians when identifying the trend because it helps them determine whether they’re bullish, bearish, or neutral on a security or market. They can use support and resistance to spot areas of supply and demand so they can make trading decisions like determining entries and exits.

While these principals are the foundation of technical analysis, other approaches, including fundamental analysis, may assert very different views.