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Technical analysis

Introduction

Support and resistance can be viewed like a glass floor and ceiling which appear to limit a market’s range of movement. Understanding these important concepts will help you develop a disciplined trading strategy.

The dynamic, sometimes volatile prices you see in the market are a result of the continuing change in the balance between supply and demand. When supply exceeds demand prices tend to fall, whereas when there is not enough supply to meet demand prices tend to rise.

Technical analysts identify trends that are forming in the markets by focusing on the price levels at which the balance changes. Although these levels are created in the market naturally and without conscious planning, they do represent the collective opinion of everyone participating in the market.

Support

A support level is the level at which a falling price finds some support to halt its decline and potentially ‘bounce’ upwards again (the lower black line in the graph).

What is happening is that potential buyers are looking at the drop in price and deciding it’s a good time to enter the market. This mops up the excess supply, until supply and demand rebalance and the decline halts. As more buyers decide to join in, the balance tips back towards demand, which pushes the price up again.

Technical analysts can identify likely support levels, but as the markets are never 100% predictable this can’t be guaranteed. It’s worth bearing in mind that if the price does pass a predicted support level it may well keep falling until it finds another support level.

Resistance

A resistance level is the opposite of a support level. It is the level at which a rising price finds some resistance to halt its advance and potentially fall downwards again (the upper black line in the graph above).

What is happening is that potential sellers are looking at the rise in price and deciding it’s a good time to sell. This generates more supply in the market, which eventually catches up with the demand and rebalances the market until the advance halts. As more sellers decide to try and achieve that high price, the collective selling force pushes the price down again.

If the price does break through a perceived resistance level, some chartists believe it’s likely to keep rising until it reaches the next resistance level.

The bears and the bulls

These are terms to describe sentiment of the two sets of markets participants.

The bears
These are the sellers. They suspect that the market price is going to fall. A bear market refers to a decline in prices in a market.

The bulls
These are the buyers. They suspect that the market price is going to rise. A bull market refers to a rise in prices of a single security or asset.

How a sideways trend changes to an uptrend

In a sideways trading range, the market is relatively stable with a limited degree of volatility – as defined by the support and resistance levels.

However, market conditions will eventually change for any of a variety of reasons. If market conditions improve, for example, this will alter the balance between supply and demand.

Here's an example sequence of events:

  1. Let’s say that a company announces positive earnings estimates.
  2. The sellers (the supply) will be less keen to sell and will hold on to their stock in the hope that the company will gain value.
  3. Buyers will be more keen to enter the market.
  4. The next time the price approaches the previous level of resistance, there will be fewer bears and more bulls than before.
  5. This allows prices to push above the previous level of resistance, and possibly ‘break out’ into a new trend.

Not all of the bulls and bears will have changed their mind, however. Most investment-related news is open to interpretation, and some investors might not have noticed it in the first place. These investors who didn’t make a move at the time of the announcement will cement the upward price movement into a new trend. Here’s how:

Some short sellers, who sold stock to open their trade, will have set stop losses above the previous resistance level. This would be to close out their position and limit their losses if the price rises. When these orders are triggered by the rising price, the short sale is closed by buying. This creates more buying – more demand – and adds to the market’s upward momentum.

Other buyers who had previously decided not to participate may notice that the sideways range has been broken and decide to take a position. This creates even more demand, pushing prices higher still.

Conditions for a new level of support

Now the market has pushed above the previous level of resistance, that level can become the new level of support.

They will have seen the price jump ahead strongly after breaking resistance, and many will decide to buy if the price returns to this level. The reasons may be down to emotional responses:

Market fear
Short sellers who previously opened a position just below the resistance level, expecting the price to drop, will want to close their position by buying if it falls back to this level. This allows them to take a small loss rather than risk the price rising again.

Market greed
Traders who previously took their profits at the resistance level may identify that a new trend is starting, and decide to re-enter the market. They’d want to do this as near to their exit level as possible.

Both of these examples add buying pressure – demand – to the market and drive prices upwards. Once this new support level is established, there will also be a new level at which buyers want to take their profits and sell.

This creates a new resistance level, leading to progressively higher support and resistance levels.

To learn more about the pitfalls of emotional trading, see our common mistakes module.

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