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Support and Resistance Levels

Two patterns that consistently show up in the price history charts of securities are support and resistance levels.


Support

A support level is established where there has been a series of closing prices that have not broken downward through a particular price. This represents a price where buyers feel that investing in the security is worthwhile. When price falls below that level, they buy. The price tends to not go below that level as long as buyers remain in control and continue to hold onto their view. There are more buyers than sellers at this point. The price may rise and then come back down again and be supported at that price level by buyers. The more times that support level is tested, the stronger the support level becomes.

Technical analysts look for a breakout downward through the support line to produce a sell signal, if the movement is sustained. High volume helps to confirm the breakout, while low volume indicates the breakout may not be sustained. A breakout is caused by a change in investor expectations. It could be caused by an earnings warning or a bad earnings report, or an exogenous event in the market. Whatever the cause, buyers are no longer willing to support the price at that level and feel that the price could drop further. When investor expectations change, it can make a sharp change. Buyers who were supporting the price level realize that they have a large position in a security whose price is falling fast so they sell some to cut their losses, which fuels the drop even more.

When the breakout is successful, the support level then becomes a resistance level.

Sometimes the breakout can be a false breakout. This is called a bear trap. The price may dip below the support line causing technical traders to sell on the breakout. If it was not caused by a fundamental change in outlook, the price may quickly move back up to the support line as sellers realize that they sold too quickly.


Resistance

A resistance level is established where there has been a series of closing prices that have not broken upward through a particular price. This represents a price where sellers feel that investing the security is getting overpriced or where there is an abundance of sellers willing to sell at that price. When price rises above that level, they sell and take their profits. The price tends to not go above that level as long as sellers remain in control and continue to hold onto their view. There are more sellers than buyers at this point. The price may fall and then come back up again and be resisted at that price level by sellers taking profits. The more times that resistance level is tested, the stronger the resistance level becomes.

Technical analysts look for a breakout upward through the resistance line to produce a buy signal, if the movement is sustained. High volume helps to confirm the breakout, while low volume indicates the breakout may not be sustained. A breakout is caused by a change in investor expectations. It could be caused by a good earnings report or a good announcement, or an exogenous event in the market like a drop in interest rates. Whatever the cause, sellers are no longer willing to resist the price at that level and feel that the price could rise further. When investor expectations change, it can make a sharp change. Sellers who were resisting the price level realize that they have a large short position in a security whose price is rising fast so they buy some to cover their shorts and cut their losses, which fuels the rally even more.

When the breakout is successful, the resistance level then becomes a support level.

Sometimes the breakout can be a false breakout. This is called a bull trap. The price may rise above the resistance line causing technical traders to buy on the breakout. If it was not caused by a fundamental change in outlook, the price may quickly move back down to the resistance line as buyers realize that they bought too quickly.




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