Support & Resistance

This
is the concept of support and resistance. Simple English words which
most of us quite familiar with and indeed, would probably be using it
quite often in our daily lives in the markets. But how many of us have
really understood the concepts behind these two seemingly obvious words?

Let
us try defining them. We have already seen that the market is a force
of supply and demand, which ultimately forms the prices. Therefore we
can define Support as “that area below the market where demand will overwhelm the supply” whereas Resistance can be defined as “that area over the market where supply will overcome demand.”

Since
the play of supply and demand is a constant one – depending on the
market cycle that is being described – the market or the stock would be
constantly moving between areas of supply into areas of demand and vice
versa. Hence one could probably state that the entire chart of a stock
would be made up of a series of identifiable areas of support and
resistance.

What makes for support and how does resistance form?
For
this we may have to back track a bit and refer to our earlier article
on the market cycle. All market moves are sponsored moves where the
stock starts a bull cycle (for example) and then this cycle witnesses a
growth and then proceeds towards maturity. Once the cycle is mature,
decay sets in and is then followed by degeneration. This leads to a
phase where there is rapid decline carrying the prices to areas where
selling gradually dries up and therefore the bear cycle which commenced
from the top dies. The area from where a rise in stock prices usually
occurs would be the support area. When prices are nearing the maturity
levels of a cycle, resistance areas are reached. These resistance areas
then reverse the trends and send the prices down until the declining
force runs out – usually around support areas – and a new move
commences. This is how stock prices normally keep moving between
supports and resistances while continuing with there never ending
bull-bear cycle.

If one looks back what has been described is
also the classic phases of a trend as per the Dow theory. The
sponsorship of a trend is the phase of accumulation; the growth of the
cycle is the phase of rapid advance while the maturity, decay and
degeneration is the phase of distribution. The decline follows the
distribution until it hits an area where accumulation starts once
again. Accumulation usually takes a long time and is done quietly. This
is an area where buyers are greater in number and therefore are able to
absorb the selling. As a result of this, prices fail to go any lower
and actually begin to inch up slowly. Thus, accumulation would always
be seen in areas of support. Since there is more buying than what is
being offered, the demand is overcoming the supply – this was the
definition that we gave at the start for a support area. It is
similarly so for the resistance. When the cycle reaches maturity, the
process of distribution begins. Here the supply of the stock increases
slowly until it begins to more than meet the demand that exists. Prices
therefore stop going any higher and then begin losing ground. This
therefore forms the resistance area for the stock. It is the area of
the prices where demand is exceeded by the supply.

Lets look
at it in yet another way. Imagine a stock, which is priced at 50
currently. Some fresh development occurs, which is however known only
to a few people. These few people would therefore be the buyers in the
stock and would begin absorbing the quantity at 50. They will do so to
the extent of their capacity and if this were now larger than the
supply available at the price of 50, the prices then would stop moving
below 50, as the demand is constant. Or, in other words, 50 become the
support. At around the same time, those who are not aware of the
development would be selling the stock; some of them possibly short
selling. There would also be set of people who are unable to decide
whether they should take a stand or not – either on the long side or on
the short side.

Let us now say that the buyers have absorbed
all the stock that is available at the price of 50 but continue to
remain hungry for more. This would then raise the prices, as the demand
will drive up the prices. This way the price will move to, say 75. At
this price, let’s say that the original buyers unloaded their stake
while there were other willing sellers at 75. The double action of
existing sellers now being strengthened by other sellers will lead to a
situation where the supply suddenly increases. This will halt the
advance of the stock. Hence 75 will act as a resistance. Even here
there would be some fence sitters that are unable to decide whether to
enter the market (either short or long) at the current price of 75.

Since
the supply is now higher, the stock price will drop and retrace back,
let’s say, all the way to around 50. Now see who all are around and
what the thinking process is :

It
can be easily seen that the number of buyers around 50 now has actually
increased three folds from the last time that the prices were around
this level! Hence the “support” at 50 becomes stronger and succeeds in
generating a lot more demand than can be matched by the supply. Prices
begin their journey back to up. Let’s say, again, that the prices now
reach 75. Now see who all are around and what the thinking process is :

Once
again, we find that the number of sellers has increased three folds.
Little wonders then, that the prices will form a “resistance ” around
75.

How long can this ping-pong match go on? Until one of the sides, gives way.
Continuing
the same example as above, lets say the prices once again drop from 75
back to 50, the same scenario as explained earlier exists. But now,
suddenly, a new seller emerges who is able to satisfy the tripled
demand. What happens? The prices would attempt to move up but meeting
with supplies at every rise, it would begin falling off and then move
below 50, as there are no more buyers to halt the prices there. As a
result, prices slide and let’s say it reaches 25 before finding fresh
support. It will then commence on a rise which, lets say, brings it
back to 50.

The
level of 50 – so reliable for the bulls the last time – is now ripe
hunting ground for bears! As the stock nears 50 again, all the above
sellers would pitch in and ensure that there is a decline once again.

Supports
once penetrated will act as Resistance in the future when the same
price level is approached again and vice versa. They have a role
reversal characteristic.

By now it would therefore be clear as to what support and resistances are and how they function. To summarize: