How to Trade Support and Resistance on a stock chart
Trading happens over exchange with various participants punching the orders round the clock. This cumulative activity creates some price zones or levels. Those levels signify something and are used as a reference by many traders. Those levels are called Support and Resistance levels.
The Invisible magic of price action?
You must have felt that a stock sometimes rebounds from a certain price zone or level many times and you wonder what makes it do so? Most of the times stock reverse from a particular price and you again fail to know why this is happening. This is not a magic. These price levels are called as the support and resistance levels.
How are these support and resistance created?
When trading action takes place in a new script. The psychology of the traders helps create those price zones where they feel the stock is either overbought or expensive(Resistance levels), Price at which stock is cheap and oversold( Support level). As the trading involves a large number of traders the probability of what they think is right level is going to be high. Simply, because of the Wisdom of the crowd principle.
After some time of trading activity, that stock develops a price pattern based on the psychology described above. Now, the new traders or investors base their future prediction of price movement based on the historical price pattern they just saw. They Just see left and find out where the price has normally taken reversal. They utilize Technical Analysis to gauge the price action and predict targets.
Let’s understand Support and resistance trading on charts.
Chart 1: Simply, observe the Green line, You will see that price hit the line twice and reversed back to upside direction. We can say that price took support at that level which was earlier held by the green line. The more times a level is respected the more is its significance.
Red Line, on the other hand, forms a ceiling and doesn’t let price to go up. Price touches that price levels on the red line and then reverse down.
So, Are the support and resistance levels unbreakable?
No, In fact, if these levels break they generally result in a fast move on the side of the break, As seen in the chart once the red line was broken on the upside. The price doubled in just 2 days.
The breaking of either line tells that the strong hands have let go. Which means the Shortsellers at Resistance level and the Buyer at Support levels are left alone by the strong players. Their stop losses hit which leads to more thrust to the breakout or breakdown.
The breaking of S&R lines may also signify that the new strong hands have arrived or they have reversed their positions. The XYZ big fish was Short on ABC stock but after the Good results the XYZ fish has reversed the position, Plus the new big investor has jumped in to buy the stock on the basis of a good result. What this means now is that the level which was good for Shortselling or profit booking is now a level where most of the buying has been done. This leads to Resistance becoming a Support level. As shown thru Blue lines.
Chart 2: Another example of Support line becoming Resistance line
CHART 3: Support and Resistance levels as per Trendlines
In above examples, we saw horizontal S&R lines. However, These levels can be on trend lines as well. See the Chart 3. On Blue trend line the price takes support on the trend line and also you can see how the support becomes Resistance in later stages.
Is there a way to Predict whether the S&R level will hold or would fail?
Yes, You can predict whether a Support and Resistance level is strong enough or it may break. To predict Technical Analysts have developed some chart patterns. Which helps in predicting the future price action. For example: In chart see Yellow lines, Do you observe a big ” W “. That is a price reversal pattern and is called a Double Bottom pattern. Similarly see the RED LINE, before the red line was broken the price formed a triangle like a pattern.
Extract: Combining chart patterns with S&R levels can improve your probability of winning trades.
This post only dealt with S&R levels on Price only. There are other methods of finding Support and resistance levels which we will know in coming posts.
Remember: Always look left on the chart to see the price action before drawing your S&R lines.
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