Support and Resistance Lines
The Basic Tools of Trading
Support and resistance lines are some of the key building blocks of trading across the board. We often use support, resistance or trend lines in our analysis and hopefully most traders and investors will understand the theory behind these lines.
Powerful Tool:
In technical analysis, the chart is a powerful way of viewing a stock's price action. By drawing lines that touch on high or low points it is possible to see certain patterns emerging. These patterns can often be used to identify possible future price action.
There is debate that these types of lines are self-fulfilling. The argument suggests that buyers and sellers look for these strategic price-action points (where the price meets these lines) and artificially boost the volume when the price breaks or bounces off the line. Whatever the merits of the debate, there can be no doubt that it is important to recognise these lines when trading.
The basic reference lines are termed support and resistance lines. Other 'reference lines' include trend lines and trend channels.
Support Line
This is a horizontal line joining all the lows of a price pattern. These lines are a low point on the chart on which the price bounces off consistently when reached.
Resistance Line:
This is a horizontal line joining the tops of a price pattern. It is a series of highs on a chart where the market continually rejects the price, thus not allowing it to go any higher.
Trading with Support and Resistance Lines
Suppport Line: Many traders would elect to buy when the price reaches this point. Experienced chartists believe that the market likes to test support lines more than once and will only look for buy signals after a second or third testing of this line. If a support line is broken then the current trend is said to be broken or in a down trend and the market will look for a lower price to set up a new support level.
Resistance Line: Many traders would elect to sell when the price reaches this point. Experienced chartists believe that the market likes to test resistance lines more than once and will only look for sell signals after a second or third testing of this line.
Duality: When Support Becomes Resistance and Vice Versa
As outlined above, when support levels are broken, it often leads to traders shorting the instrument, beit shares, Forex (FX) or an Index. What is interesting and is usually misunderstood by traders is that this broken suppport level often becomes the trader's new resistance level.
Chartists argue that if the trading price rises again toward the former 'broken' support level, it often fails to move above this level because at that point, traders sell in an attempt to recover any earlier losses and break even. This forms a new trading pattern where the price rises up to the new resistance level and drops. This failure at the new resistance can occur for a some time after a break of a support level.
On the other side of the coin, when a resistance level is broken, price activity often continues to climb in value. However this rise is unstable because it is largely based on stop loss orders that traders place, and can result in a drop in the price.This is even more so for Forex half-hourly charts.
Example
The trend line on the S&P/ASX200 (XJO) chart in winter 2007 below shows definite congregation of price action at the level of 6180 - 6190 (shown in Orange)
By using the low points in May 2007, a 'support' line can be drawn. This is a line where there were 2 distinct bounces off of this level, suggesting that the XJO appeared to be supported at this level.
A bullish trader who was going long (or positive) on the XJO may decide to place their stop loss level just below this line in the belief that if the support level was breached then the XJO would continue to fall.
At the end of July the XJO fell from it's highs of 6436 and pierced the support line, falling to the 5500 region. On the upward leg from the August 2007 lows the previous support line turned into a 'resistance' level.
A trader who may have shorted the index near the support/resistance line highlighted, may choose to place their stop level just above this region, as in the event the market broke back though this area, an upward bias is likely to resume, with the highlighted line likely to become a support region once more.
