Understanding support and resistance levels can greatly assist both traders and investors. It’s all about understanding how prices tend to move. There are usually psychological barriers to prices moving beyond key levels. Support and resistance is all about understanding where those levels are and how prices are likely to move from that level.
Think of a support level like a physical floor on the share price. Say that a share is trading at $4.30 and imagine there is a floor at $4.00. As the price moves towards $4.00, it has a difficult time getting past that price because the floor stops the price from going below $4.00.
In fact you will probably see the price bounce off $4.00 as it tries to drill a hole in the floor. The more times that the price touches the floor, the weaker the floor will become. This occurs until the floor is broken. Once the floor is broken, the share price is free to fall to the next floor or support level.
Once a support level has been broken it becomes a resistance level.
A resistance level is like a ceiling. Say that a share is trading at $4.30 and it is moving upwards but there is a ceiling at $4.50. It tries to break it but can’t so it keeps on bouncing off this point. The more times that the share price touches this point, the weaker the ceiling becomes until the share price breaks past it and that resistance level is now a floor to future price movements.
As you can see, support and resistance levels are simply areas that prices seem to have difficulty moving past. They are significant because once broken, it leaves the share price relatively free to move until it hits the next support or resistance level.
So how do you identify support and resistance levels?
Support and resistance are important concepts in charting or technical analysis. In technical analysis, the past casts a shadow over the future by repeating itself in patterns. Hence support and resistance levels are usually historical levels where the share price had difficulty moving through in the past. Often these can be previous high points or low points.
There are many other tools you can use. The Fibonacci series is a series of numbers which has an uncanny ability to describe patterns in nature and natural relationships. These proportions can also be applied to the way that share prices move. Important percentages include: 23.6%, 38.2%, 50%, 61.8% and 78.6%. The level of 50% isn’t really a Fibonacci ratio but nevertheless is considered an important level.
When using the ratios, usually the distance from the beginning of a trend to the end is measured and then the ratio is applied to the gain or loss to work out where the next level of support or resistance will be.
For example, if the share price has risen in a trend starting from $3.00 and ending at $5.00 before falling, then the first Fibonacci support level should be at 23.6% of $5.00 – $3.00 which is $2.00 so at $4.52, the next 32.8% support level would be at $4.24 and then the 50% retracement would be at $4.00 and then so on and so forth.
Essentially support and resistance levels are psychological barriers for the share price which act a floor to the share price when the share price is rising (support) and like a ceiling when the share price is rising (resistance).