What are Support and Resistance Levels and Why do they Exist?
Support is a concentration of demand and resistance is a concentration of supply which are sufficient to stop and possibly reverse a trend. These are historical levels where large amount of shares traded in the past.
There are three different types of players active in the market. Those who are long, those who are short, and those who are do not have positions but are watching and waiting for an opportunity.
So say a stock trades a considerable amount of volume right at the $20 for one month. This is how a sideways market is traditionally explained. As viewed on a chart this would be a perfectly horizontal line which extends for a month. In the real world stocks never stay at such a precise level for so long but this is just a hypothetical example.
Then suppose the stock goes to $21. Those who bought the stock are happy that they are correct but they are angry they didn’t buy more. They say to themselves that if it comes back to $20 they will buy more. Conversely those who shorted it at $20 are angry that they are in a losing position and say to themselves that if the stock comes back to $20 they will cover their positions and break even. The third group is those who are watching. These could be traders who saw that the stock spent a lot of time at the $20 level, so when it moves away they are watching to see if it sells off. They buy it when it comes back to $20 because they think that the other buyers we discussed will be there as well. If there are other buyers, the traders consider this a low risk buy…meaning that if they change their minds and don’t think they are right they can turn around and sell it to one of them at $20 so they won’t lose any money.
So now we see why $20 will become a support level. It is because there is a large vested buy interest or demand for the stock at that price. Because this example is of a neutral or sideways market, meaning that the forces of supply and demand are roughly equal, the sellers will eventually push it back down from $21 to $20. If it was a Bull market those who were at $20 wouldn’t mind paying a slightly higher price and this is what causes Bullish Markets or Uptrends. More on that later.
When you understand these dynamics it is easy to understand how levels that were support become resistance, and levels that were resistance become support. Suppose that our hypothetical stock trades below $20 and drops to $19. This would happen if the market went from neutral to a more Bearish Stance. More people were willing to sell at $20 than there were to buy. And because they are now bearish, some sellers are willing to accept prices below $20 because they believe that markets will continue to go lower.
So now the dynamics have reversed. Those who bought at $20 and were happy that it went to $21, are now upset and mad at themselves for not selling it and taking their profit. Now they have a loss, but they vow to themselves that if it rallies and gets back to $20, they will sell it so they can get out at breakeven. And those who shorted it at $20 are happy and say to themselves that if it gets back to $20 then will short more. So now we have a large amount of supply and sell interest at the $20 level.
This is Truly an Amazing Phenomenon...
If you really think about support and resistance levels in the Benchmark Indices such as the NASDAQ and S&P 500 it is an extraordinary phenomenon. The fact that the markets have ‘memories’ and how prior levels continue to be relevant is a truly amazing and astonishing phenomenon. How can this be? At the different times when the prices of the Indices are at these same levels interest rates are at different levels, as are oil prices and expectations. And the individual stocks that make up the index are all at different prices. It is important to understand that charts are actually a graphical study of mass psychology.
There are literally hundreds of millions of investors and tens of thousands of stocks and somehow we act like a bee hive or ant colony. Individually we think we make our own decisions but somehow most of us become part of the crowd. I recently read a book about ants and ant colonies (I know...I’m weird). Think about this. When an ant colony decides to move from one location to another, it’s not like they have a meeting and make a group decision. Each ant only knows what the ants in its immediate vicinity is doing. The individual ants don’t know what is going on. They are merely following the actions and signals of its immediate peers. Yet somehow the aggregated actions of hundreds of thousands of ants take on a group knowledge and the colony knows how to move. It’s a similar thing with humans and group behavior.
I find it interesting that when I look at charts prior to the late 1970s I do not see levels in the major benchmarks that are as clearly as defined as the ones I see now. This is due to the great popularity of ETFs. The same hypothetical investor who had $10,000 and bought five different stocks in the 1960s or before would now have the option of investing in an ETF. So the same dynamics that caused our hypothetical stock to develop support and then resistance at $20 are causing very precise levels in Benchmark Indices.
The Good Thing is that we don’t need to understand exactly ‘why’ this happens…just be glad that it does...
So, there you have it. Support and resistance levels are easy to identify and yet at the same time are a fascinating study of mass psychology. But the good thing is that it isn’t important to have a complete and total understanding of why this happens. Do you really understand why the light goes on when you flick the switch?
Understanding supply and demand will enhance your investment process. If you are considering making or liquidating an investment, look to see if there are clear levels that will influence the action of the stock. For example, if you are considering selling XYZ and it has just hit an important support level, you can wait to see if it will bounce and you can get a better price. If it is approaching resistance levels, you should sell it before all the other sellers enter the market potentially knocking it down.
Why Round Levels Are Important...
The vast majority of investors are more likely to sell (or buy) an asset at a nice even number like 20 than 19.93 or even a higher number like 20.07. This illogical behavior is because people are comfortable thinking in nice round numbers. I have seen this behavior in experienced money managers and traders who went to the best schools…it isn’t just Joe Sixpack or Billy Punchclock. Therefore, when a market runs into a nice round number level like 20 or 50 or 100 or 1,000, it will have more resistance there than at levels that are not round. You may ask ‘why sell at 19.93 when I can sell at 20?’ What could possibly be the advantage to doing that? It’s a good question.
But think about it. If you sold 1,000 shares at 20, you would get $20,000. If you sold 1,000 at 19.93 you would get $19,930. So we are talking about a difference of $70 on $20,000. Expressed as a percentage it doesn’t even show up until you get to the third decimal place. And while you are patiently waiting to get a 20 ‘handle’ on your trade, a huge computerized sell program may come in when the stock is at 19.98 and knock it all the way down because computers are not susceptible to the same mental hang-ups that humans are. Your stock may not get back to 20 for months, if not years, or maybe even ever. I have seen this happen more times than I can remember. What makes matters worse is when you wanted to use the cash that you were going to raise from the sale to buy a new position, and the stock takes off while you’re waiting and you are sitting there vowing that you will never invest or trade again. You lost two times because you wanted to save seven cents.
There will be even more sellers at the 20 level if the stock has been down to 10 in the preceding year or so. The temptation to double your money at nice round prices is very appealing to the human psyche, regardless of the educational or professional background or lack thereof. Suppose the stock peaks around 20 in October, and then sells off to 15 in November. Investors who wanted to sell at 20 and missed it will now become more aggressive than before if it approaches those levels again. So if in December it gets back to around 20, sellers will become very active.
What are Trends and Why they form...
Even someone with no experience in the markets can see that prices clearly move in trends if they look at a simple price chart. Prices do not jump around in a random way. When viewed on a chart which displays prices has time progresses it is easy to see that prices can move in three possible ways. They can move up or down, and if prices stay the same when viewed on a chart they will move sideways or horizontally.
One thing that is certain is that sooner or later the trend will change, and at these times profitable trades can be entered and exited. The key is having the patience to wait. Beginner traders feel as though they need to be actively trading every day. But in reality, there might be 3 or 4 obvious trades in a sector in a year. Not being too active and being out of the markets prevents overtrading and getting whipsawed.
Trend lines appear to be simple things but if you think about it closely they are dynamics graphical representations of the supply and demand dynamics is a given market. The fact that so many perfectly straight lines can be drawn is actually a fascinating phenomenon. Most take this for granted.
Now that you understand the concepts and dynamics that cause support and resistance levels to form, it is easy to understand how trends develop. They too are caused by supply and demand. Let’s think about a hypothetical example. Let’s say that the market is neutral. Most people think the markets are either rising or falling but a good amount of the time the markets are in equilibrium. This is known as ‘trading sideways’ or a ‘horizontal market.
50% are Bulls, and 50% are bears. Within these groups there are traders and investors who have different time frames. We can now understand how our hypothetical stock can fluctuate between $20 and $21. The buyers who have a longer-term bullish outlook but are currently neutral are content to stay at $20 and patiently accumulate what they feel will be a successful long-term investment. The sellers who have a longer-term bearish outlook but are currently neutral are happy to stay at $21 and sell at prices at the high end of the range before they decline.
In between these two levels…from 20.01 to 20.99 are different players that have shorter term times frames. The same dynamics we discussed with longer term investors are the same with shorter term…they are fractal in nature. For example, there could be day traders who are content to stay at $20.45 and $20.55. So in a hypothetically neutral market this could go on forever and prices will fluctuate between $20 and $21. This would be considered a ‘sideways’ or ‘horizontal’ market. The market can be considered 50% Bullish and 50% Bearish, which is neutral.
Now let us suppose that in our hypothetically perfect market for some reason 10% of the Bearish players become Bullish leaving 40% Bearish and 60% Bullish. This simple shift would break the neutral equilibrium and cause an uptrend. Now when XYZ sells off of $21 and closes back in on the important $20 support level, these now bullish investors decide that they don’t want to wait until prices fall all the way back to $20. Because they feel that prices are ultimately going higher they say to themselves that it makes sense to pay $20.05.
Now crowd behavior and the herd mentality starts to kick in. The next time the stock rises back to $21 and sells off again, players will think that it rallied the last time, so it probably will again. Now they are willing to pay a little bit more…say $20.10 this time instead of $20.05 because they don't want to miss the nest move upwards. And so on and so on and so… On properly drawn chart this phenomenon of mass psychology can be demonstrated with an uptrend line.
The same dynamics come into play in downtrends or Bear markets too...just on the opposite side. What is interesting, and is obvious by a simple look at a chart is that markets decline much faster that they rise. This is because markets sell off on fear while they rise on hope. Fear is a much stronger emotion than hope. This simple common sense observation pretty much refutes most of what academia promotes. Markets are not efficient and they do not follow random walks.