There are price levels that market traders appear to recognise as floors or ceilings to price action. The floor is commonly known as support and the ceiling as resistance. Support is always below the current price and resistance above.
Support is created as a result of the market making a low and resistance as a result of price making a high. The more times the market tests these levels and holds, the better the support or resistance is said to be.
Support develops as the result of price testing a price level and failing to break lower. In fact if price repeatedly rallies off a particular level, even if it's only twice, we can view this as confirmation of the support level. The more often it rallies from a level the better the support.
Resistance is like a price cap, a price that the market can't seem to get above. It is a barrier to higher prices, a level where sellers outnumber buyers.
Using a hi, lo, close bar chart, basic support is found by locating chart lows and drawing a horizontal line across to the current date. The more points picked up along this line the better the support. A more refined support line can sometimes be drawn a little higher, disregarding some outliers, if it picks up more points.The reason we look for support is for the ideal opportunity to buy the market and minimise the risk.
Resistance, on the other hand, is located at price peaks, highs. They could be major tops or just minor aberrations and the strength of the resistance will reflect not only the location, but also the frequency with which the market has tested the level.
Buy off support and sell against resistance. Sell on a break of support and buy on a break out above resistance. Once support has been broken it becomes resistance and conversely once resistance has been taken out it becomes support.
Some people use support and resistance levels to lean on, in the case of support, or to lean against, in the case of resistance. It is often easier to buy just above support or sell just below resistance and while price holds these levels we can say we're leaning on the support or leaning against the resistance levels. Some traders will wait for support to be broken to act as sellers or for resistance to be taken out, to be buyers.
Stop losses are often placed at these levels or just beyond, and day traders will sometimes seek to set off these stops and act against them by taking the other side, in which case they are actually doing the opposite of what the technical indicator is indicating. This is a contrarian approach and can often be very successful, especially for short-term traders. Longer-term traders tend to benefit more using support and resistance levels in a more classic way.
© The MacLean Group Pty Ltd ACN 096 967 038. All rights reserved 2003. This article has been prepared by The MacLean Group and licensed to ASX. The views are those of the author and not of ASX. This material is educational and it is not intended to constitute financial advice.