We are often asked what is the best and most reliable tool a trader can have and I always answer ” support & resistance”.
Demand & Supply
You see, at the very heart of it, the market is driven by supply and demand. When supply is greater than demand we will have falling prices and when demand is greater than supply we get rising prices. What Support and Resistance levels do is show you where there is likely to be a change in the supply/demand dynamic. In other words, it tells you at what price level we are likely to see demand overtake supply or vice versa…..and by extension, it can tell you whether you should be going long (buying) or going short (selling).
Support vs Resistance
A support level can be described as a price below which there is no supply or where no one is willing to sell so you will have serious consolidation and sideways movement at this price level, as supply dries up and people hold on to their shares. What will eventually happen is that demand will overtake supply at this level and prices will rise. A Resistance level is the opposite, and can be described as a price above which no one is willing to buy so you will have some amount of consolidation followed by a drop in price as supply exceeds demand at that level.
Really Understanding Support & Resistance
In order to really understand this, you have to just consider the fact that the market is made up of sellers and buyers who are constantly “negotiating” for good prices. The sellers want to sell at the highest price they can get and the buyers want to buy at the lowest price and what we often end up with is something in the middle and this is all done through the Bid/Ask process ( notice that “BxA” thing on your trading quotes?). Now anytime we get to a point that the sellers think that they cannot let go off their shares for anything less than a price they consider as fair, you will see supply dry up and eventually there will be more buyers than sellers at that price. And since supply is low/scarce the price can only move up and once it starts moving up then more buyers will be interested in buying it because they think it will move higher. This is what is described as the market finding support.
Conversely, whenever we get to a point where buyers feel that a stock has reached a price that is too high to get in, then they won’t buy anymore and may even start selling. This is where you find resistance i.e a price above which new buyers are not interested in getting in and so the demand dries up and leaves only sellers so the price can only go down from there.
Makes sense? If it doesn’t just read it again.
This can be applied to any instrument that trades on any market …..from Stocks, to Commodities to Forex. And it can be applied to many different time frames. Often, you can visually identify these levels on a chart by just looking at the price/points at which a stock has made more than one attempt to go up or down but has not gotten beyond that price despite getting there several times.
As you can see, this is really powerful stuff and it is often overlooked by many traders.