Are you a new trader, learning the ropes of trading stocks? Are you trying to figure out how to accurately identify and use key support and resistance levels in your stock strategies? Or perhaps you’re an experienced trader struggling with creating effective trading plans based on such technical analysis elements. Whatever stage of the game you find yourself at, don't worry - understanding support & resistance can be easy once you understand the concepts involved! This guide will walk through what these terms mean, why they matter for your trades, and how to properly incorporate them into your trading plan. With this knowledge by your side, soon enough any novice or experienced stock trader should be able to make smart decisions about when to enter and exit positions using these two fundamental market tools.
What are support and resistance levels?
A support level is a price point below which a security is expected to find buying interest and, as a result, is unlikely to fall further. Conversely, a resistance level is a price point above which a security is expected to find selling interest and, as a result, is unlikely to rise further.
The identification of support and resistance levels is an essential component of technical analysis. Many technical indicators are designed to identify these levels, with the hope of providing traders with an edge in predicting future price movements.
One common technical indicator used to identify support and resistance levels is the moving average. When a security's price approaches its moving average, it may be bouncing off of support or encountering resistance. Other indicators that can be used to identify these levels include the Relative Strength Index (RSI) and the Stochastic Oscillator.
It's important to note that support and resistance levels are not static. They will change as the security's price changes. Furthermore, they are not always accurate predictors of future price movements. However, they can be helpful tools for traders who are looking to make informed decisions about their trades.
Why do they matter in stock trading?
A stock's price is determined by the collective perceptions, expectations and, most important, actions of ALL of the people who trade it. The three most important groups of people who affect a stock's price are buyers, sellers, and market makers.
When buyers and sellers trade a stock, they are exchanging ownership of the stock. The bid price is the price that a buyer is willing to pay for a stock. The ask price is the price at which a seller is willing to sell a stock. The difference between the bid and ask prices is called the spread [bid/ask spread]. The price at which buyer and seller agree to trade is called the trade price... aka the "print" price... it's the price[s] that you see scrolling across the screen on CNBC during the trading day.
Market makers are people or institutions who buy and sell stocks for their own account in order to provide market stability and profit from the bid/ask spread. They provide liquidity to the market by making it easy for buyers and sellers to trade stocks. When there is more demand for a stock than there are sellers, market makers will sell/sell short stock at higher and higher prices until demand is satiated. When there is more supply of a stock than demand, market makers become buyers in order to provide market stability for traders. When buyers and sellers are far apart, the bid/ask spread widens and a stock becomes illiquid.
How can you identify key support and resistance levels in your stocks?
There are a few key ways to identify key support and resistance levels.
- The first is to look at historical prices. If a stock has been consistently bouncing between a certain price point, that's likely to be a key support or resistance level.
- Next, you can use indicators like moving averages to identify general support and resistance levels.
- Another way to identify key support and resistance levels is by drawing trendlines along swing highs and swing lows
- Finally, you can use price action clusters and previous highs and lows like my own TAOST Power Zones to provide strong evidence of support and resistance levels
Once you've identified them, you can use support and resistance levels to help you make trading decisions. For example, if a stock is testing a key resistance level, you might decide to close a long position and/or to sell short. Similarly, if a stock is approaching a key support level, you might consider buying. Knowing where support and resistance levels are in your market can give you an edge and help you make more better informed decisions.
What are some common techniques used to trade based on support and resistance levels?
There are some common techniques that traders use to trade based on support and resistance levels.
- Breakout - One technique is to wait for price to break up through resistance or down through support, and then enter a trade in the direction of the breakout.
- Reversal - These trades are just the opposite of Breakout trades. Traders assume that support and/or resistance will hold and take trades with stops just beyond the support or resistance level. For example, day traders often consider the low of the day in a stock to be a good support level and thus they will often buy as price approaches the intraday low.
- Continuation - Another technique is to use indicators such as moving averages or trendlines to help identify when a support or resistance level is being tested. If the indicator shows that the support or resistance level being tested is failing, traders can enter into a trade in anticipation of a break out.
- Context - A third technique is to use price action to spot buying and selling pressure at support and resistance levels. This is my personal favorite and the source of much of my trading success. Traders can look for candlestick patterns or bullish and bearish engulfing patterns to help them determine when there is buying or selling pressure at a support or resistance level and trade accordingly.
How can you use support and resistance levels to create effective trading strategies?
When it comes to trading, support and resistance levels are, perhaps, two of the most important factors to consider. As I've shown, support levels indicate where buyers are likely to enter the market, pushing prices higher, while resistance levels represent a point where sellers are likely to enter the market, pushing prices lower. By considering and using these levels as part of your trading plan, you can identify key points where you may want to initiate new positions, add to existing positions or take profits altogether.
For example, if a stock is approaching a resistance level that has been tested multiple times in the past, you may want to consider taking profits if it reaches that point. Conversely, if a stock is nearing a support level that has been tested multiple times in the past, you may want to consider opening a new position. Keep in mind, however, that support and resistance levels are not foolproof and should not be used in isolation. Other factors such as price behavior, volume dynamics and overall context should also be considered when making trades.
In order to be a successful trader, it is essential that you understand and are able to identify support and resistance levels in the stocks you trade. These levels can impact both your entry and profit taking points, as well as the all important stop-loss levels. In this article, I've provided you with a few tips on how to use support and resistance levels to create a winning trading strategy. By following these tips, you will be better equipped to find trading success.