Why do stocks bounce when they reach yesterday’s lowest price?
Why do they reverse when they hit last week’s highest price?
Why do you see the same levels repeating over and over again?
I’m talking, of course, about support & resistance. One of the most fundamental and yet very misunderstood concepts of trading.
Open any book on trading and I guarantee you there is a chapter dedicated to support & resistance. If there isn’t then it’s not a very good book.
It is a concept that is so basic and fundamental and yet so many traders have no idea why these important levels form or why they are important. Newer traders have such an intense desire to make money that they will take everything at face value as long as some experts tell them it works and never question why it works.
So I will try to explain why support and resistance levels form on your chart and how to trade them effectively and I’ll try to do that in as few words as possible.
The Market Is An Auction
The stock market or any other market we trade is nothing more than a continuous auction. An auction with no end.
It is basically a large group of people who buy and sell to each other, all the time.
The price of a stock climbs higher simply because buyers are willing to pay higher and higher prices and it goes lower because buyers are not willing to pay higher prices so the sellers need to lower their offers.
An uptrending stock will continue moving higher until the buyers decide that the prices they are paying are too high. At that point, the supply (sellers) will overwhelm the demand (buyers) so naturally, prices will fall like shown on the screenshot below.
The price will keep falling until it finds enough demand to overwhelm the supply and at that point, the trend will reverse again to the upside.
Now here’s where the resistance of this auction process comes.
The market has memory. It remembers what has happened in the past, especially the recent past and that’s because the market is composed of people and people, of course, have memories!
As the price reaches the level that nobody wanted to buy previously it is very likely that those groups of traders will not want to buy this time around either. If that happens, the price will reverse at exactly the same area it did last time. And that is what we call a resistance level.
The same is true, of course, in the opposite sense. As the price is falling it will keep falling until people think it’s cheap enough to buy. If it bounces at that level and then at a later stage returns to it then it is very likely that people will once again think that it is low enough to buy. That would be support.
You see, there’s nothing mystical about prices reversing from the same price it did in the past. It isn’t algos or mathematics or anything like that. It’s just people.
If you went to the store and you wanted to buy apples and you saw that they were on sale you would buy. If you went back the next week and saw that they were on sale again the probably you would buy again.
In that market, the sale price would be support. If the store owner increased the price beyond the regular selling price of apples then maybe you wouldn’t buy them and instead wait for another sale. If you went in the store the next week and saw the price was still too high then it’s likely you wouldn’t buy this time around either. That high price would be resistance.
So you see, the stock market is not very different than the farmer’s market.
How do you find these important support and resistance levels? Always look left on your chart. Support is where the price has bounced from one or more times in the past. Resistance is just the opposite.
If you just remember that traders are likely to repeat what they did in the past that made them money and trade accordingly then you will be on the right path.