Trendlines
We can see from the preceding examples that when an asset’s price is held constant, it cannot go up or down. One of the most common types of support/resistance, this static barrier can shift over time due to the upward or downward trends in the value of financial assets.
That’s why it’s helpful to have some background knowledge in trending and trendlines before diving into the study of support and resistance.
Resistance levels are formed during an upward trending market as the price action slows and begins to move back toward the trendline. A reaction occurs when the price moves in the opposite direction of the trend.
There is a wide range of factors that can cause a reaction, such as profit taking or near-term uncertainty regarding a specific issue or industry. As a result, the market experiences a “plateau” effect, or a temporary peak in stock price.
When the market is trending downwards, on the other hand, traders will look for a succession of falling peaks and attempt to connect them with a trendline.
Most investors will keep an eye on the price as it nears the trendline, expecting to see selling pressure as the asset approaches a level that has historically pushed prices lower. In order for a trendline to be considered reliable, prices must have touched it three times.
Price may retrace several times over extended time periods, but only if the trendline is particularly strong. It’s important to note that the trendline is drawn lower than the price action in an uptrend, and higher than the price action in a downtrend.
A level’s support/resistance is considered to be stronger the more times the price has historically been unable to move beyond it, whether the level was discovered with a trendline or some other method.
Support and resistance levels are used by many technical traders as entry and exit points because they typically correspond to the prices most influential to an asset’s direction.
At these levels, most traders are confident in the underlying value of the asset, leading to higher-than-usual volume and making it much more difficult for traders to continue driving the price higher or lower.
As the price of a security declines toward the wider support of the trendline, many traders will pay close attention to the situation, as this is an area that has historically prevented a significant decline in the value of the asset.
As can be seen in the Newmont Corp. (NEM) chart below, a trendline can serve as a stable foundation for an investment over a long period of time.
Round Numbers
The inability of a price to rise above a round number, such as $50 or $100 per share, is another feature of support/resistance. The stock market reflects the general tendency of investors to think in terms of whole numbers.
Inexperienced traders often make decisions to buy or sell when the price of an asset is near a round number because it is easier to conceptualize.
Additionally, many retail investors and large investment banks set target prices or stop orders at round price levels, rather than at prices such as $50.06. This is because many orders are placed at the same level, making these round numbers effective price floors.
A level of resistance would be created, for instance, if all of an investment bank’s clients placed sell orders at a suggested target of $55. It would require an extremely high number of purchases to absorb these sales.
Moving Averages
Most technical traders rely on technical indicators like moving averages to help them anticipate the direction of short-term momentum. It’s common practice for those who struggle to draw trendlines to instead use moving averages.
Moving averages, as can be seen in the following chart, are dynamic lines that average out previous price data, making it easier to spot levels of support and resistance.
Take note of how the moving average acts as support for the asset price in the below chart during upward trends and as resistance during downward trends.
When price lines cross above a key moving average, traders can use this to anticipate an upswing in the market, and when price lines cross below a moving average, they can use this as a signal to get out of a trade.
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When a moving average is applied, support and resistance levels are often “automatically” generated. To find the best moving average for their trading time frame, most traders will try out a variety of different time periods.
Keep an eye on this space for our next article on support and resistance fundamentals
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