Understanding Support and Resistance

Forex trading can be very tricky business, but it is easier to understand if you can follow the logic of its workings. Understanding the support and resistance of various currencies and securities will help you offset potential losses and realize better gains. Resistance is the upper end of a trading price range and support is the lower end. When a security keeps trading within a specified range of resistance and support, it tends to create strength. This strength may develop over a few weeks and even over a year, depending on the range being examined.

The later part of the last decade saw a prime example that will explain the concept of support and resistance. Air Canada’s stock during a particular period traded between $5 and $7, which is a very narrow range. So it has support at $5 and resistance at $7. At the lower range, which is called “support”, millions of shares changed hands at about the $5 level. This volume led to creation of strength at the support level or “floor”. In layman’s terms, for the price to fall below $5 point, it would have taken an extraordinary volume of shares.

On the other end, the higher value trading price was hovering around $7 for some years. Somehow the price could not break through this level, because the sellers always outnumbered the buyers when the price reached $7, due to excessive buying at “support” level. This created resistance at the $7 level, a resistance that could not be broken through to a higher level. This created a very level playing field for investors who bought heavily at support level and offloaded at the resistance level. The traders made god profits through this trade and also created strength at both levels because of the volumes traded.

When the price of a security goes through the resistance level and moves upwards, the level changes to a support level. This means that, what was once the resistance level becomes support level after some time passes on breaking the resistance level. As an automatic measure, a resistance level also forms over time. If the markets work on a bad economy, the reverse cycle is also possible.

Support and resistance depends on trending and trend-lines. Again, understanding both these concepts depends upon each other and are symbiotic in nature. Trend is an important factor that indicates the breaking of support or resistance levels. Trend-lines are indicators of future breakages and thus help an investor to invest wisely for a profit. Short term trend or level of support and resistances formed in the short term (“plateau”) are not real market intelligence but are effects of temporary economic shifts. Uncertainty is always an element of forex or security trading and thus spread over a longer period of time, uncertainty decrease and thus the risk.

Support and resistance, both are formed in short and long time by the factors of volumes and time. More the time, more is the strength at both these levels. The place of strength however is formed by consistent and good volumes traded over a longer period of time. Investors, however find it easier to break through a two-week resistance strength of a million share as against a two-week resistance strength of 10 million shares.

Support level is strengthened by bulls (or buyers) due to their control through volume buying to strengthen the position. Conversely resistance is controlled by bears (or sellers) by controlled selling to keep prices at the optimum. Representing an agreement of doing business, the bulls and bears agree to a price of trading.

Since investor needs and expectations tend to change, often suddenly, development of support and resistance price levels is noticeable on price charts over a period of time. If the needs and expectations are sudden, the levels of support and resistance are bound to break. However, the cause seems to be insignificant compared to the effect. New expectations and new needs may form new levels of support and resistance.

Supply and demand also plays a part as in the traditional economic formula. N increase in price will see more buyers in a short term but less in the long term depending on the trend. A decrease in price, on the other hand, will see some selling but will taper out on a short term compatible trend.

The roots of any mechanical and statistical tools of analysis are deeply rooted in the theory of supply and demand and support and resistance levels are no exception.

Despite a new generation investors emerging with greater understanding of risk and its management, the trend remains as it is and the formulae remain as they. IT has only added to further competition and refining of tools to give a faster and truer picture of the markets at any given period of time.