Support and Resistance Points: Technical Analysis 101
Understand how the market moves… and you increase your odds of success.
In theory, markets are pushed higher and lower by fear and greed – two of the strongest psychological drivers of all assets.
The more fear there is in an asset, for example, the higher the chance the value of that asset will decline. The more greed there is in an asset, the higher the chance the value of that asset will increase.
Or, many times you’ll hear technical analysts refer to the ongoing tug of war between bulls and bears, or the struggle between buyers, which represent demand, and sellers, which represent supply.
We see it happen all the time in equities, markets, ETFs, and commodities.
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When looking at fear and greed on a chart, we begin to look at the technical parameters of support and resistance, or a price floor or ceiling.
When prices are falling to the floor, support represents the moment when buying begins to overwhelm selling and prices begin to bounce back. Conversely, when prices move to the ceiling, resistance is the point where selling begins to overwhelm buying and price increases begin to reverse.
You can identify support and resistance by studying charts.
Look for a series of low points when a stock continues to fall to a certain level, but then doesn’t fall any more. Typically this is support. And when you find a stock that rises to a certain high, but rises no more, you have found resistance points.
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The more times a stock bounce off support and resistance, the stronger these support and resistance lines become for technical analysis. If something repeats itself again and again, it becomes a stronger indicator of potential pivots at high or low points on a chart.
Such technical indicators are important trends to watch because they can be used to make trading decisions and identify the potential for trend reversals. For instance, if a trader finds that his or her stock is running into overhead resistance points, where it has failed many times before, that trade is likely to take profits because of historical failure at that point.
Here’s why technical analysis works so well.
1. Stock Prices Tend to Move in Trends
For a technical analyst, the trend is always his friend. That's why most technical trading strategies are trend following. That includes the broader market trends as well as those of individual stocks.
Once a trend has been established, technicians know that the future price movement will likely continue in the same direction. Of course, any break in this trend is often where technicians decide to sell. That's why fundamentals are of little use to technicians. To them a stock is either moving up, down, or sideways.
2. Markets, Like People, Repeat Themselves.
Technicians believe that since markets are made up of people, they follow predictable patterns. As such, they attribute the repetitive price movements in stocks to market psychology. The belief is that once a consistent pattern of behavior has been established it can be used in the future to provide good entry and exit points.
Now which one of these schools of thought is the best remains a matter of contention. After all, they are radically different in their approach. A technical analyst believes the markets are 80% psychological and 20% logical, while the fundamental analyst believes in the reverse.
Unfortunately, not everyone sees technical analysis as useful.
Fundamental investors have very little use for support and resistance, for example.
To them, they have difficulty coming to terms with the idea that past prices can be predictive of future prices. For example, Warren Buffett, Peter Lynch, and Benjamin Graham are great fundamental investors.
Aside from being wildly successful investors, they only use fundamental analysis to dig up a market-beating stock. In a world of charts, trend lines, and candlesticks, they have relied entirely on fundamental analysis to earn their famous fortunes.
Their disdain of technical analysis is so complete that Buffett once remarked, "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer."
Meanwhile, Lynch observed, "Charts are great for predicting the past."
And Graham before them who famously said, "In the short term the market is a voting machine, but in the long run it is a weighing machine."
While we won’t argue with what has worked for them, the argument for technical analysis is as strong as fundamental analysis.
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