Support and Resistance
Think of security prices as the result of a
head-to-head battle between a bull (the buyer) and a bear (the seller).
The bulls push prices higher and the bears push prices lower. The
direction prices actually move reveals who is winning the battle.
Using this analogy, consider the price action of
Phillip Morris in Figure 6. During the period shown, note how each time
prices fell to the $45.50 level, the bulls (i.e., the buyers) took
control and prevented prices from falling further. That means that at
the price of $45.50, buyers felt that investing in Phillip Morris was
worthwhile (and sellers were not willing to sell for less than $45.50).
This type of price action is referred to as support, because buyers are
supporting the price of $45.50.
Figure 6
Similar to support, a "resistance" level is the
point at which sellers take control of prices and prevent them from
rising higher. Consider Figure 7. Note how each time prices neared the
level of $51.50, sellers outnumbered buyers and prevented the price
from rising.
Figure 7
The price at which a trade takes place is the price
at which a bull and bear agree to do business. It represents the
consensus of their expectations. The bulls think prices will move
higher and the bears think prices will move lower.
Support levels indicate the price where the
majority of investors believe that prices will move higher, and
resistance levels indicate the price at which a majority of investors
feel prices will move lower.
But investor expectations change with time! For a
long time investors did not expect the Dow Industrials to rise above
1,000 (as shown by the heavy resistance at 1,000 in Figure 8). Yet only
a few years later, investors were willing to trade with the Dow near
2,500.
Figure 8
When investor expectations change, they often do so
abruptly. Note how when prices rose above the resistance level of
Hasbro Inc. in Figure 9, they did so decisively. Note too, that the
breakout above the resistance level was accompanied with a significant
increase in volume.
Figure 9
Once investors accepted that Hasbro could trade
above $20.00, more investors were willing to buy it at higher levels
(causing both prices and volume to increase). Similarly, sellers who
would previously have sold when prices approached $20.00 also began to
expect prices to move higher and were no longer willing to sell.
The development of support and resistance levels is
probably the most noticeable and reoccurring event on price charts. The
penetration of support/resistance levels can be triggered by
fundamental changes that are above or below investor expectations
(e.g., changes in earnings, management, competition, etc) or by
self-fulfilling prophecy ( investors buy as they see prices rise). The
cause is not as significant as the effect--new expectations lead to new
price levels.
Figure 10 shows a breakout caused by fundamental
factors. The breakout occurred when Snapple released a higher than
expected earnings report. How do we know it was higher than
expectations? By the resulting change in prices following the report!
Figure 10
Other support/resistance levels are more emotional.
For example, the DJIA had a tough time changing investor expectations
when it neared 3,000 (see Figure 11).
Figure 11
Supply and demand
There is nothing mysterious about support and
resistance--it is classic supply and demand. Remembering "Econ 101"
class, supply/demand lines show what the supply and demand will be at a
given price.
The "supply" line shows the quantity (i.e., the
number of shares) that sellers are willing to supply at a given price.
When prices increase, the quantity of sellers also increases as more
investors are willing to sell at these higher prices.
The "demand" line shows the number of shares that
buyers are willing to buy at a given price. When prices increase, the
quantity of buyers decreases as fewer investors are willing to buy at
higher prices.
At any given price, a supply/demand chart (see
Figure 12) shows how many buyers and sellers there are. For example,
the following chart shows that, at the price of 42-1/2, there will be
10 buyers and 25 sellers.
Figure 12
Support occurs at the price where the supply line
touches the left side of the chart (e.g., 27-1/2 on the above chart).
Prices can't fall below this amount, because no sellers are willing to
sell at these prices. Resistance occurs at the price where the demand
line touches the left side of the chart (e.g., 47-1/2). Prices can't
rise above this amount, because there are no buyers willing to buy at
these prices.
In a free market these lines are continually
changing. As investor expectations change, so do the prices buyers and
sellers feel are acceptable. A breakout above a resistance level is
evidence of an upward shift in the demand line as more buyers become
willing to buy at higher prices. Similarly, the failure of a support
level shows that the supply line has shifted downward.
The foundation of most technical analysis tools is
rooted in the concept of supply and demand. Charts of security prices
give us a superb view of these forces in action.
Traders' remorse
Following the penetration of a support/resistance
level, it is common for traders to question the new price levels. For
example, after a breakout above a resistance level, buyers and sellers
may both question the validity of the new price and may decide to sell.
This creates a phenomena I refer to as "traders' remorse" where prices
return to a support/resistance level following a price breakout.
Consider the breakout of Phillip Morris in Figure
13. Note how the breakout was followed by a correction in the price
where prices returned to the resistance level.
Figure 13
The price action following this remorseful period
is crucial. One of two things can happen. Either the consensus of
expectations will be that the new price is not warranted, in which case
prices will move back to their previous level; or investors will accept
the new price, in which case prices will continue to move in the
direction of the penetration.
If, following traders' remorse, the consensus of
expectations is that a new higher price is not warranted, a classic
"bull trap" (or "false breakout") is created. As shown in the Figure
14, prices penetrated the resistance level at $67.50 (luring in a herd
of bulls who expected prices to move higher), and then prices dropped
back to below the resistance level leaving the bulls holding overpriced
stock.
Figure 14
Similar sentiment creates a bear trap. Prices drop
below a support level long enough to get the bears to sell (or sell
short) and then bounce back above the support level leaving the bears
out of the market (see Figure 15).
Figure 15
The other thing that can happen following traders'
remorse is that investors expectations may change causing the new price
to be accepted. In this case, prices will continue to move in the
direction of the penetration (i.e., up if a resistance level was
penetrated or down if a support level was penetrated). [See Figure 16.]
Figure 16
A good way to quantify expectations following a
breakout is with the volume associated with the price breakout. If
prices break through the support/resistance level with a large increase
in volume and the traders' remorse period is on relatively low volume,
it implies that the new expectations will rule (a minority of investors
are remorseful). Conversely, if the breakout is on moderate volume and
the "remorseful" period is on increased volume, it implies that very
few investor expectations have changed and a return to the original
expectations (i.e., original prices) is warranted.
Resistance becomes support
When a resistance level is successfully penetrated,
that level becomes a support level. Similarly, when a support level is
successfully penetrated, that level becomes a resistance level.
An example of resistance changing to support is
shown in Figure 17. When prices broke above the resistance level of
$45.00, the level of $45.00 became the new support level.
This is because a new "generation" of bulls who
didn't buy when prices were less than $45 (they didn't have bullish
expectations then) are now anxious to buy anytime prices return near
the $45 level.
Figure 17
Similarly, when prices drop below a support level,
that level often becomes a resistance level that prices have a
difficult time penetrating. When prices approach the previous support
level, investors seek to limit their losses by selling (see Figure 18).
Review
I kept discussions of price action, investor
expectations, and support/ resistance as concise as possible. However,
from my experience working with investors, I am thoroughly convinced
that most investors could significantly improve their performance if
they would pay more attention to the underlying causes effecting
security prices: investor expectations and supply/demand.
The following is a very brief review of the support/resistance concepts discussed in this section.
Figure 18
- A security's price represents the fair market value as agreed between buyers (bulls) and sellers (bears).
- Changes in price are the result of changes in investor expectations of the security's future price.
- Support levels occur when the consensus is that the price will not move lower. It is the point where buyers outnumber sellers.
- Resistance
levels occur when the consensus is that the price will not move higher.
It is the point where sellers outnumber buyers.
- The
penetration of a support or resistance level indicates a change in
investor expectations and a shift in the supply/demand lines.
- Volume is useful in determining how strong the change of expectations really is.
- Traders' remorse often follows the penetration of a support or resistance level as prices retreat to the penetrated level.
