If you have been following the stock market or even people talking about stock markets, you must have heard these terms used to describe various levels in the market. Let us understand, what these terms mean and what makes people so obsessed with them.
What is the Support level?
We all know that supply and demand move the market up or down. In a falling market, the supply is usually higher than the demand. At some level the supply decreases and demand increases making the falling market reverse the trend or even stop falling further. This level is usually referred to as the Support level by the traders.
What is the Resistance level?
In a bull market, the demand is higher than the supply. At some level, the demand rises and supply decreases and this would cause the market to break the current trend. This level is referred to Resistance level by the traders.
Psychology of support and resistance levels
What we call a market is just a collection of people, trying to exchange goods, so the market changes direction only when the psychology of people changes.
If the market reversed direction at a level, there would be lots of traders, who missed the chance to buy or sell, before the market changed direction. Now when the market is again reaching the same levels, naturally they expect the trend to reverse, like it did last time. So if last time, the market bounced back from a level and people missed the chance to buy low, they are going to buy, once the market reaches the last level from where it reversed. If there are lots of people who are buying, it would create a huge demand, and once the demand overcomes the supply, the market would reverse the trend and go up. This creates a support level at the previous low, it almost feels like there is some force supporting the market above this level.
Similarly, if the market has fallen from a level, people would fear that it is going to fall again from this level, which makes them exit their positions. If a lot of traders exit their positions at a certain level, it would suddenly increase the supply of the stock, causing the prices to drop.
Support and Resistance levels work like a self-fulfilling prophecy, if a lot of people believe it to be true, it works, otherwise, it does not. So if I feel there is a support level at certain levels, while a majority of trader feels otherwise, it would not work. For support, resistance, or any other technical analysis to work, a big majority of traders have to believe that it works.
How to identify Support Resistance levels
Support and Resistance levels come in many different forms. The most common types are Price range, Trend lines, Moving Averages
Price Ranges
The most common form of support and resistance levels is usually a price range from where the markets have turned around. These levels are a broad range of prices beyond which markets have not been able to break, the more times the market returns from these levels, the stronger the support and resistance levels are believed to be.
Trend Lines
Trend lines are a popular form of support and resistance levels, in a falling market the lower highs tend to make a line that is trending downward, this trend line forms a resistance level which the subsequent lower highs should not break for the trend to continue.
Moving Averages
A moving average over a long duration depicts the longer-term trend of the market and similar to trend lines, the lower highs or higher lows would not break the long-term trend, otherwise, the trend is considered broken. 200 DMA seems to be the most popular moving average for most traders.
What happens when support and resistance levels are broken?
Once a popular level is broken the trend of the market is considered to be changing. If the market was bullish and a strong support level has been broken, the market sentiment would turn negative. Once the trend is broken, the momentum-chasing traders would be cautious and would wait to see a new trend emerge before they get into a trade. This in turn is going to re-affirm the downward trend, causing the demand to fall further.
Once the market reaches a previously broken level of support and resistance, the functions reverse as the sentiments had changed once the trend was broken. So a previous support level would become a resistance level and a previous resistance level would become a support level.
Conclusion
Support and Resistance are good ways to gauge the market trend and make reasonable assumptions on the future direction of the market, we should always be careful to not rely too much on any one way of understanding the market and use our own judgement to trade. If there is a news in the market about a war, no support levels is going to hold, similarly if the government reduces the income tax or makes some big financial change, no resistance is going to hold.
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