Tips on Technicals - Support Becomes Resistance
Support and Resistance
Simply stated, support and resistance are respective price levels at which prices stop going down or up. A price in any market is one at which buyers and sellers have agreed upon fair value. If more buyers think that price is fair, they will attempt to buy. This, in turn, raises demand and prices rise. As prices rise, buyers become less active and sellers become more active. At some point, buyer and seller activity will balance and this price level becomes resistance. The more times a market touches a resistance (or support) level, the more significant it will become. This is because buyers and sellers simply do not perceive fair value to be any higher than that level. The market will have difficulty in rising further unless something happens that causes perceived fair value to rise.
Let's use an example in the stock market. Resistance for the stock of XYZ company is at 50. The market bounces around below 50 for several weeks until the company announces better than expected earnings. Now, both buyers and sellers think that fair value is higher than 50. The market breaks out of its trading range and trades higher until buyers and sellers agrees that fair value is 55.
An interesting thing now happens. If the market trades back down to 50, buyers who missed the earlier breakout will see their second chance to go long. The market bounces up off the 50 level which has now become support. If the market makes it back to the 55 level, sellers who missed their chance to unload their stock at the high earlier will become active. This increased supply resists the market's attempt to move higher so prices once again fall back.
The chart of MATIF June Bonds (figure 1) illustrates this point. The two highlighted areas show how the market traded lower off a resistance level. Later, it failed to break through on its second attempts as sellers who missed the first opportunity took advantage of the second.
Support and resistance levels can be found in all time frames, from tick to daily to monthly and longer. The 120, and 126 and 135 levels in dollar/yen have been significant levels for five years (figure 2). When analyzing the major trends in a market, going back far enough in time will reveal prices in the past that have been significant market turning points. Analysts predicted that the price of Crude Oil before the 1991 Gulf War would reach $38 US based on cash prices going back to before there were Crude Oil futures.
The German DAX Index rallied several times after its July 1992 sharp decline and each time it was stopped at a level that provided support back in 1991 (figure 3).
Measuring the Move
Trading ranges are simply areas of price action between support and resistance levels. In the example on the previous page, XYZ traded in a 50 - 55 range. In the June 1993 COMEX Gold Chart (figure 4), prices in November and December 1992 were locked in a range from about 335 to 343. The market started 1993 by gapping down and establishing a new trading range. Former support at 335 became resistance and new support was established at 327. At the end of March, the market gapped up through resistance and rose until the old resistance level at 343 stopped it.
When the market fell through support in January, the question to ask was "Where should I look to buy this market back again?" The answer could be found by measuring the height of the previous trading range. Markets tend to move integral multiples of the previous trading range and in this case that was $8. The lower range was, in fact, $8 wide. Had prices fallen through 327, the market could be sold with an eye on the 319 level.
Note that prices in the real world can violate our rule in that the market briefly traded through resistance in February. Technical analysis is subject to the analyst's interpretations.
Channels, like ranges, can also measure price breakouts. The channel in figure 4 was about $13 wide so when the breakout occurred in March, prices rose $13 to $343. Since this is the same as a previous resistance level, it becomes a very significant price for the future. The more technical indicators that agree, the stronger the signal. In the next chapter, we'll cover more patterns and in more detail.
