Last Updated on 17 November, 2020 by Samuelsson
Support and resistance is the concept of specific levels in price, where demand and supply meet, creating a barrier to the up or downside that price struggles to get past. Support and resistance levels are determined by the surrounding price action or indicator levels, which are carefully guarded by market participants. Thus, a breach of a support or resistance level would suggest that the market is strong enough to break free from and begin a rally in the direction of the breakout. Conversely, a failure to breach a support or resistance level suggests that the market will revert, lacking the strength for a breakout.
In this guide, we will learn what support and resistance is, how to use it in trading and what pitfalls you should avoid.
What Is Support?
A support level is a level in price that acts as a barrier to the downside. When the market approaches the support, traders anticipate that the odds of a market reversal are large. Therefore, you could say that price tends to “bounce” on or around support levels, which are determined by past market action. Previous lows, highs and indicator readings are some of the most common determinants of support levels.
In the image below, we see an example of a support level that’s made up of a recent low.
As price approached the support level, it gapped down, performed a doji, gapped up again, and then began a bullish trend. This is typical behaviour in support and resistance zones. Investors don’t know if the level is going to hold or not, and until there has been a significant move to guide the market up from the support line, it could also be breached, which would indicate a short-term bearish trend.
What Is Resistance?
The logic of a resistance level is the same as the one of the support level. However, exactly as the name implies, it’s a resistance rather than a support.
Below we see a resistance level that hinders price from moving further upwards.
What Is the Difference Between Support and Resistance?
The difference between a support and a resistance, is that a support level is a level where the market is expected to pause during a short term downtrend, while a resistance level is a level where it’s expected to pause during a short term uptrend. In other words, a support line is a level where price is more likely to bounce, and a resistance a level where price typically finds resistance when rising.
Depending on the type of market, one of the two could be more significant as an effect of the long term trend of the market. For example, a support line in the S&P 500 should be given more weight than a resistance level, given the long term upwards-bias of that very market. This is because the upward drive of the market repeatedly will force the market above its previous resistance lines, and cushion the market as it falls.
To explain this further, one could say that the market and the underlying companies are valued somewhat more for each day that passes. This is because we expect the economy to grow, and so our companies’ revenues. Thus, the previous resistance levels were formed during another overall lower valuation of the market, and are not as significant anymore.
Of course, this assumption doesn’t hold as well in a bear market as in a bull market. Still, knowing the overall long term trend of the market and its special traits, could provide traders and investors with some clues on how to deal with support and resistance lines.
Resistance Level Turning Into Support Level
Sometimes, a resistance level will become a support level after the support has been breached. What typically happens is that the market bursts through the resistance, continues up, and then reverts. If the market treats the now breached resistance level as a support, that is also what it has become!
Resistance becomes Support
What happens in the image, is that price bursts through the support, which is a previous high, and then successfully retests the level again. The resistance has become a support level.
Support Level Turning Into Resistance Level
Of course, the opposite may also happen. Below is an image of a market that breaches a resistance level, reverts and then continues down. In this case, the support has become a resistance level.
Why Support and Resistance Levels Work
In financial markets, decisions are made by humans. For a long time, there was the belief that humans are rational decisionmakers that consider all logical aspects of an issue, to make an informed decision. This belief, which is the premise of the Efficient Market Hypothesis, is not correct!
Markets are driven by humans, who in turn are very reliant on their emotions. A price chart, to a large degree, is a representation of emotions such as optimism, greed, fear, and pessimism. When market participants buy and sell stocks or other securities, in many cases, the driving force will be emotions and not solid, rational facts.
Applying Psychology to Resistance and Support
In the financial markets, at any given time, there are three types of market participants:
- Bullish traders who are long in the market
- Bearish traders who are short in the market
- Neutral traders who hold no position
Since the bullish trader believes that the market is going to rise, he is creating demand by going long (buying a share). Unlike the bullish trader. the bearish trader is providing the supply by shorting the market.
This, in its core, is the rule of supply and demand in the shape of two different types of traders.
When price approaches a resistance level, bullish traders will begin to question their short term faith in the market. Since they know that the market may revert around a resistance level, some may choose to exit their positions. In other words, the bullish balance in supply and demand becomes bearish, resulting in that the resistance level holds the test.
The contrary happens once the market approaches a support level. Bearish market participants who have driven the market downwards, assume that there is a chance that the market will turn up again around the support level. Therefore, some of them will choose to liquidate their positions, which in effect means that they send out a buy order. This increase in demand will make the market turn around and the support level will hold.
For breakouts from resistance or support levels (which will be covered later), the situation is a little different. Once a resistance or support level is breached, market participants assume that the price will continue in the direction of the breakout. This, in turn, impacts demand and supply to fuel the market in the new direction.
For false breakouts, the change in demand and supply is insufficient, and the market reverts, leaving the resistance or support level undamaged.
What makes a Zone Significant?
Support and resistance can be drawn from price action, indicator levels, or moving averages. However, there are other factors that can help you to determine the significance of a certain level. This enables you to better estimate the likelihood of the level holding or not. These are some factors that add significance to support and resistance levels:
- Number of Touches
Volume is an indication of how many shares or contracts that were traded during a specified time period. The more heavily a market traded during a test or creation of a level, the more significant that level will become. The fact that the support or resistance level withstood a heavily traded market is a sign of significance.
Number of Touches
The more times a level is tested and holds, the more attention it will get. This results in that more market participants are ready to either close short positions or sell long positions once the market approaches the resistance or support zone. Thus, the level becomes more significant.
There are many different levels that could act as resistance or support zones. If there are many supports in proximity to each other, the market will find it harder to penetrate that support level. Here is an example of a cluster of resistance levels, consisting of previous highs:
The longer time a level has held, the more significant it gets. The market will find it much more difficult to penetrate a resistance level that was formed one year ago, than one formed last month.
Fierce Market Action
If the market experienced high volatility with sudden and sharp movements, support or resistance levels created in such conditions become more significant.
Breaching a Significant Zone
If a significant support level is breached, it will often produce a fiercer and more significant reaction. Below is an example of when a significant support level was breached, causing an expansion of market volatility and paving the way for a short term downtrend.
As you can see, the support level was tested four times. On the fifth attempt, it seemed like it would hold as well. However, the market breached the support level with a significant over-night gap, and then continued down for quite some time.
You will find that breaches of support or resistance levels by gaps is quite common in the markets!
Different types of Support and Resistance
As we’ve mentioned before, there are many types of support and resistance levels. Here, some of the most common ones are listed:
Highs and lows
Using Highs and lows to draw support and resistance zones is very common among traders. Supports are established at previous lows, and resistances at previous highs.
In the image above, you see how the highs and the lows constrain market activity to a price range. Once price reaches either the resistance or support, it reverts.
A trend line is a line that connects two highs or two lows. If two lows are connected, the trend line becomes a support level. If you connect two highs, the trend line becomes a resistance level.
Trend lines work best in trending markets. When the market is trending, it means that it’s either rising or falling for a longer period of time. If the trend is bullish, the market is going to perform higher lows, which in themselves become support levels. The same thing happens to the higher highs of a bullish market, that become a resistance level. Below you can see an image of a bullish market where the trend lines act as support and resistance. This is also called a trend channel.
You might also notice that the resistance eventually was penetrated and turned into a support level. This is apparent when price retests the upper line after the breakout, and then continues upwards.
Trend lines are some of the most used resistance and support levels and often work very well. However, as with all other resistance or support levels, trend lines will be broken eventually. In those cases, traders must make a decision to redraw the trend line to fit with the new lows or highs, or declare it dead.
You can read more about trend lines here
By round numbers we mean even numbers such as $100 or $2500. Markets tend to find these levels harder to breach than other levels. This has two reasons:
First, traders, and especially inexperienced traders, use to place profit targets or stop losses on round numbers. The reason is that it’s more straight forward to choose a round number than a decimal level. Also, traders use to find surge above an even number as more significant than, for example, above $74,5. Therefore they often sell once price moves above an even number.
Second, large investment banks use to put target prices around even numbers. However, such large firms have large quantities of shares that cannot be sold in one order. Therefore, they use to place many different orders at slightly different levels around the target price. Often, these vast quantities of shares coming out on the market act as a barrier for further price increments.
Experienced traders use to not place orders on round numbers, since they know price is prone to reverting at these levels. Placing a stop loss at round numbers could have the consequence that you’re stopped out of the trade right at the reversal of the market.
Below you can see how Apple (AAPL) reached the resistance zone around $100 in 2009, and failed to rise further.
Moving averages are some of the most used technical indicators and can also be used as support and resistance. They work by smoothing price action by taking an average of the x-last data points.
When using averages as support and resistance, there are many settings to choose from. Some of the most well-regarded ones when it comes to reliability, are the 10, 20, 50, 100, and 200-period moving averages. Among these, the 50 and 200-day moving averages are considered especially accurate. Below is an image of the 200-day moving average acting as a support:
When looking at daily charts, especially in stocks and market indexes, the 200-day moving average is quite likely to act as support in a bullish trend. and resistance in a bearish trend. This is because the 200-day moving average tends to be under the price graph in bearish trends, and above in bullish trends.
Here you can read more about moving averages.
Traders can also use trading indicators as support or resistance. Typically, you look at the indicator reading as if you were looking at a price chart. Thus, a low in the indicator could become support and a high could be interpreted as resistance. Generally, the same methods as those used with the price graph can be applied to trading indicators.
Below we see an example of how a low reading in RSI acted as a support level.
Traders can use Fibonacci to find potential support and resistance levels. The most common use of Fibonacci is with so-called Fibonacci retracements. Fibonacci retracements are ratios of a price swing that tend to act as support and resistance levels. The most common Fibonacci retracements are 61,8% and 38,2%.
Fibonacci retracements are drawn on the chart by measuring the distance from a peak to a bottom or vice versa. That distance is then multiplied by the ratio( 61,8%, 38,2%…), which is the distance from the peak or bottom that will act as support or resistance.
To better understand this, let’s begin by showing an image:
The distance from the peak to the bottom is the distance that we use as the base for the Fibonacci retracement calculation. That means that the 61,8% Fibonacci level in the image above is calculated as:
bottom + (peak-bottom*0.618)
You can see that both the 61,8% level and 161,8% levels became resistance zones. If you look at the 31,8% level, which is not arrow marked, you can also see that this level acted as short term resistance.
How To Use Support and Resistance in Mean Reversion
Traders often use support and resistance zones to find better entries. For example, if the market approaches a previously tested support level, traders know that there is a chance that price is going to bounce one more time. They may then use this insight to go long at the support level.
Similarly, if the market approaches a resistance level that has been tested in the past, they might go short once price hits the resistance level.
One of the most common ways of trading support and resistance, is with mean reversion. Traders see the market approaching one of the levels as a sign of oversold or overbought conditions. However, using support or resistance lines alone as a trading system is dangerous. Supports and resistances are breached all the time, and the expected turnaround of the market will often be replaced with a rally through the resistance or support lines. That is why traders need to use support and resistance together with other filters or conditions, such as an indicator, or a price pattern.
One indicator that is widely known for its ability to catch the mean-reverting nature of the equities markets, is the RSI indicator. By combining an oversold reading of the RSI with a support line, traders can increase their odds of taking a profitable trade. Here is an example of how you could combine RSI and support levels:
There are also many types of price and candlesticks patterns that can be of help. For example, a doji right at a support level is a strong indication that the market will revert. As is normally the case with dojis, the longer the tail, the better the signal. If the market gapped down before and gapped up afterwards, that’s an even stronger signal. Below is an image of a doji at a support level.
Trading Breakouts From Resistance or Support
Sometimes the support or resistance levels are not respected and price bursts through the level that should have acted as a barrier. In those cases, we have had a breakout.
When trading breakouts, we trade in the direction of the breakout. For example, if a resistance was breached, we would go long, Below is an example of a such a trade:
While trading breakouts seems easy in theory, the reality is not as simple. Support levels are not exact. They should rather be seen as zones where there is a higher probability that the market will revert. This immediately makes defining a breakout much more challenging. How do we know if there has been a breakout, if the breakout level in large is unknown?
Adding Distance to the Breakout Level
To solve this issue, traders usually add a distance to the breakout level. So, if the resistance zone is around $130, they might decide to only take a signal once the market exceeds $131. By adding distance to the breakout level, you decrease the risk of acting on false breakouts. However, once acting on a breakout, the market has already performed part of the breakout, which means that there is less of a move for you to profit from.
The distance that you should add to the resistance level differs from market to market. In general, one can say that there are three different approaches
- Fixed dollar based distance
- Fixed percentage based distance
- Volatility adjusted distance
1. Fixed Dollar Based Distance
The fixed dollar based distance means that you simply add or subtract a certain amount of dollars to the support or resistance line. For example, if you are watching for a bullish breakout from the $262 level, you may add $1 dollar to the price.
The disadvantage of this method is that it doesn’t care at all for market valuation. 1$ in a market that trades at $1253 dollars is much less than in one that trades at $10. If using the fixed dollar based distance, you need to adjust the distance to fit with the market.
2. Fixed Percentage Based Distance
Using a percentage based distance, means that you add a percentage of the market price to the breakout level. For example, you may add a 1 % distance to the breakout level in a market that currently trades at $100. The breakout level then becomes $101.
The benefit of using this method is that it takes into account the size of the market. This could be essential, since a large market, unlike a small one, will cover large dollar distances with ease.
3. Volatility Adjusted Distance
The volatility adjusted distance is a method that uses a measure of the market’s volatility to calculate the distance. Usually, traders use true range or a moving average of the true range (ATR) to measure the normal ranges of the market. Then they multiply their measure of volatility by a value that could be everything from 0.05 to 10.
The benefit of volatility-adjusted distance is that it doesn’t assume that the level of volatility is static. Volatility changes with time, and therefore your breakout level might benefit from adapting to the changes in market conditions as well. Hopefully, this will reduce the number of false breakouts, especially in high volatility settings.
Support and Resistance in Backtesting
Defining support and resistance in backtesting can be quite tricky, depending on what price action that you want the resistance/support to be drawn from. For example, while a previous high can quite easily be programmed, a trend line demands coding knowledge that’s beyond the scope of the typical beginner or intermediate trader. The basics of defining support and resistance are covered more in detail in our article on backtesting.
Resistance levels vs Resistance Zones
It’s important to remember that resistance or support levels are not exact levels. The market seldom respects support and resistance levels down to their decimal value. Instead, it treats them as zones, and a support level could very well be penetrated and still remain valid, as long as price reverts within a reasonable distance from the support. Below you see an image where a support level acts as a zone, rather than as an exact level.
Still, there are occasions when you will see that the market turns around on the exact level of the resistance or support. This type of behaviour is generally more common when a market trades in narrow, short term ranges. If the range is wider, support or resistance levels tend to work more as zones than exact levels.
- Support and resistance is one of the most helpful branches of technical analysis.
- Support defines a level where the market is likely to turn up-
- Resistance is a level where the market is likely to turn down-
- There are many different methods to find support and resistance. Moving average, highs and lows, and trend lines, are a few.
- Breakouts and mean reversion are two trading styles where support and resistance can be helpful.