There are three main ideas that any investor should be able to identify when looking at a stock chart:
- Trend
- Support
- Resistance
In today’s article, we are going to focus our attention on support and resistances.
What are supports and resistances?
A support is a price level in which the price is likely to stop after a rise. Following the same idea, but in the opposite way, a resistance is a price level in which a fall is likely to stop.
Why do you need them?
Supports and resistances are essential for two things:
- To know when to buy and sell
- Risk management
Actually, number one leads to number two, but let’s talk about each of them specifically.
If you are able to know that a price is close to a resistance, even when the stock looks good, it is a good idea to wait and see what happens with the resistance. If it breaks it, it shows strength, and that could be a good moment to buy. But if it stops there, a correction may start. Remember that corrections are not always a movement against the last trend. Sometimes they can be done by a sideways movement with time. In any case, you do not want a stock that is going to fall or be in a sideways, so it is not a good candidate for purchase.
On the other hand, when a price in a positive, long-term trend is close to a support after a correction, it may be a good moment to buy (but not if it breaks it!).
For risk management, it is more or less the same. When you are about to buy something, you can look at the next support to set your stop-loss and the resistance to set a profit goal. If the trend goes in the same direction as the goal and the winnings – if everything goes well — are bigger than the losses – if things go wrong – then you may be facing a good opportunity.
How to know where a support or resistance is
Supports and resistances are not the product of magic. The logic behind them is quite simple, and you may find your own behaviour behind them.
Imaging that you buy a stock at 10. It starts to go down, 9, 8, 7… and after some months or even years, it starts to go up. If you are like many other investors, you will hold this stock “until you do not lose with it”.
This means that you will wait patiently seeing the losses in your portfolio during this long time.
There are two main psychological reasons that prevent you from selling when losing:
- You have to accept that you were wrong.
- You have to explain to your partner that you have lost a lot of money.
These two reasons are a fallacy that we will explain in another article, but the result of them is that as soon as the stock returns to the level you bought or goes a little higher, to be able to say you won in the operation, you will feel you have to sell.
Won’t you wait until the stock rises more? Likely not because after years of suffering with the stock, seeing it with very low prices, you now feel angry with it, and you want to lose sight of it.
All of this does not only happen to you. It also happens to thousands of other investors resulting in a zone that will become a resistance. In simple words, in that level, people star to sell.
Thus, resistances are levels where the prices have been accumulated previously as shown in the red box below.
Something similar happens with supports in the blue box above. Remember that there are many people who operate in the short side of stocks.
This is not the only way. You can also make a line connecting the tops to see a resistance (as the green line) or lows to see a support. The more touches the price makes in the line, the more important it is. But in general, they are not so important as the regions of accumulation explained above.
As a final note, do not forget that supports and resistances are not at a specific price, but at an area or range of prices.
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