A stock's price is the result of many different factors, but fundamentally is determined by supply and demand like any other good. Investors will buy when they think a stock is priced too low, and sell when they believe the price has hit a high point. The price levels that correspond to these points are known in technical analysis as support and resistance lines. Support and resistance lines can give a trader valuable clues about the possible future price movement of a stock.
Many traders think of technical analysis as the unemotional application of lines, using past price movements to predict future ones. But there are actually solid fundamental reasons that support the validity of these charting tools. The graphs with supply and demand curves many learned in their introduction to economics course were a nightmare for some, just common sense to others.
But they are useful for more than just deciding how many widgets to produce, and at what price. When applied to the price of a stock, the interpretation in plain English is that the price of a stock goes up due to increasing demand, and decreases because of increasing supply. Where the two lines cross determines the current market price, and the where the market reaches a (temporary) balance.
This explains why support and resistance lines develop. A support line is the level that a stock's price generally does not fall below, because at that price level there is sufficient demand for the stock to stop a downtrend. In other words, buyers for the stock emerge as it reaches an attractive valuation. A resistance line is the level above which a stock's price generally will not rise, because at that price level a sufficient supply of stock is available to stop an uptrend. The owners of stock begin to sell and take their profit as it reaches a level where they believe it is fairly, or even over, valued.
Horizontal lines are drawn on a chart to indicate areas of support and resistance. The low that the stock price has “bounced off” of in the past is identified as support. This price is where buying pressure overtakes selling pressure, and the market moves higher. Resistance is the price on the chart where selling pressure overtakes buying pressure, and the market moves lower. A resistance level is identified by a previous price high on the chart. Red lines in the chart below illustrate support (lower) and resistance (upper) lines.
Notice that where the support and resistance lines are located changes over time. Support was initially at about $24.70 and resistance at $30. But after a sustained sell off, new support and resistance lines formed at lower prices. The longer that prices trade in a support or resistance area, along with how many "hits" it has taken, the more significant the area becomes.
Once they have been decisively broken, support levels can transform into resistance levels and vice versa. A break through a resistance line shows that the buyers have won out over sellers, and are determined to bid the price of the stock higher than previous highs. Once the resistance line is broken, another resistance line is created at a higher level. In that case, the previous resistance line often becomes the new support level.
The distance between support and resistance lines can also be important. The farther apart the two lines are, the stronger each line is. It also pays to watch the volume of shares being traded, since the strength of the lines increase if trading is very active while the price is bouncing between the lines.
Technical analysis can be used to consistently reduce your risks and improve your profits, and support and resistance levels are important tools for any technical analyst. Knowing whether a stock's price is nearing a support or resistance level allows you to be aware that a reversal may be likely. Understanding support and resistance lines gives you an additional trading edge that will help improve your odds of making profitable trades.