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 know 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?
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.
This gives us a the classic rule of support and resistance :
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:
Support lies beneath the market and shows demand.
Resistance lies above the market and shows supply
Prices move constantly from one area of support into an area of resistance.
Supports once broken will reverse to resistance and vice versa.