Technical analysts use support and resistance to identify areas of supply and demand.
It’s important to identify general trends, but technicians seek to understand why trends happen, or the investor behavior that creates trends. Technicians use the concepts of supply and demand to explain why trends occur and how human behavior shapes stock prices. Supply is the number of shares available for purchase at a certain price. Demand is the number of orders for shares at a certain price. There are a number of factors that affect supply and demand such as a company’s earnings and earnings potential, the strength of the overall economy, and alternative investment returns. But, a technical analyst doesn’t worry about these fundamental factors; instead, they attempt to track changes in supply and demand and make decisions accordingly.
The changes in supply and demand drive stock prices up and down. Generally, when more investors are eager to buy (or demand is high), prices rise to entice more people to sell and increase supply. And when more investors are eager to sell (or supply is high), prices fall to entice more people to buy and increase demand.
Here’s what this looks like in terms of the highs and lows of a trend. High demand drives the price of the stock toward a high—this is known as a rally. The stock starts to peak as supply and demand meet equilibrium. Then, as supply surpasses demand, price pulls back, or falls. This is also known as a retracement. When supply and demand meet equilibrium again, the stock establishes a new higher low, then rallies to a higher high on strong demand.
FIGURE 1: DEMAND CAUSES RALLIES AND SUPPLY CAUSES PULLBACKS.
The changes in price are reflective of changes in supply and demand. For illustrated purposes only.
One reason stocks make higher highs and higher lows is because of institutional money. Institutions are large money managers like mutual fund companies, pension funds, investment banks, insurance companies, etc. When institutions take a position in a company, they invest thousands, if not millions, of dollars. If they were to show that much demand at one time, the stock price would skyrocket to find enough supply to meet all the orders. Once the sellers filled the orders, the price would likely return to somewhere near the initial price, resulting in huge losses for the institutions.
Therefore, institutions are methodical in the way they accumulate shares. They commonly buy a little at a time for a few days, knowing their actions will drive the stock price higher. Then they wait for the stock to pullback. After the stock has pulled back, they buy more shares at this lower and more desirable price, causing the price to rise again. They then stop buying, allow the stock to pull back, and start the buying cycle again.
Areas of supply and demand are known as support and resistance. Because of the story they tell about price, support and resistance are significant actionable levels—places where investors buy and sell. Let’s discuss how to define these levels.
Lows are known as support levels. As you’ve learned, these are areas where demand starts to increase—areas where investors are more willing to buy.
FIGURE 2: EQUAL LOWS FORM HORIZONTAL SUPPORT.
Support lines are caused by high levels of demand that investors have identified as a good price to buy the stock. For illustrated purposes only.
Support works like a floor—it “supports” the price from going lower. However, support isn’t usually one specific price, but a range.
Highs are known as resistance levels. These are areas where supply starts to increase—areas where investors are more willing to sell.
FIGURE 3: EQUAL HIGHS FORM HORIZONTAL RESISTANCE.
Resistance lines are caused by high levels of supply that investors have identified as a good price to sell the stock. For illustrated purposes only.
Resistance is a ceiling—it “resists” the price from going higher. Price reaches this level, stops, and turns down. Like support, resistance isn’t usually one specific price either. And the more highs at a certain level, the stronger the resistance level is.
Investors use support and resistance levels to identify the direction of the trend and project future price movement. Let’s look at each of these uses.
First, investors use support and resistance to identify the direction of a trend. They connect lows and highs with diagonal support and resistance lines—these act as trendlines. Investors generally draw support on uptrending stocks and resistance on downtrending stocks to make the trend more visible. To create a trendline at support, draw a line connecting as many lows as possible. When support and resistance lines are parallel, they create a price channel. Short-term traders use price channels for swing trading.
Investors also project future price movement by drawing horizontal support and resistance levels. An area of resistance from months ago can act as support at a later time, just as old support can act as new resistance.
FIGURE 4: OLD RESISTANCE OFTEN BECOMES NEW SUPPORT.
Support and resistance are like floors in a skyscraper, the ceiling for one level is the floor on the next. For illustrated purposes only.
Technicians use trend to determine whether they’re bullish, bearish, or neutral, and then identify support and resistance to spot areas of supply and demand. After completing these steps, technicians will determine their entry and exit signals.
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