Understanding the basic concept of support and resistance informs the investor of the significance of stock market moves. It can send a signal of strength or weakness in a specific move. It can tell the likelihood.
THE DOW THEORY
The idea of market support and resistance goes back to the Dow theory, originated by Charles Dow and further developed by a later editor of the Wall Street Journal, William Hamilton.
Support is a point in a declining stock market where buyers start
buying. Resistance is the point where sellers start selling. When a market
declines, analysts look lower for the next area of support. The strength of
an area of support is determined by how many times the level stopped
former declines. If it stopped only once, it is weak support. If market
declines stopped at the same level more than once, it is stronger support.
When the market falls through strong support, it has a tendency to drop
much further.
Resistance, the opposite of support, is a level where stock market advances stopped in the past, where stock buyers stopped buying. If advances were stopped only once or maybe twice, it is weak resistance. If several advances were stopped, it is stronger resistance. When the market breaks through resistance, it tends to rise much higher. Sometimes support or resistance levels are at precisely the same point. Other times they are not so exact but rather are a range of support or resistance.
Keep in mind, these are tendencies, not guarantees. The stock market does what buyers and sellers determine, not necessarily what someone thinks it’s supposed to do.
ONE BECOMES THE OTHER
Resistance becomes support, and support becomes resistance. The two conditions of support and resistance switch roles (Figure 1). When resistance is penetrated, resistance becomes support. If the Dow Industrial Average stops a few times at the 10,000 level, then rises to 10,100, the former resistance level becomes support. On the other end, if the market falls through a support area, that area becomes new resistance.
In November 2002 the Dow Industrial Average encountered previously established resistance at 8,996 points. It corrected, dropping until it found support at 7,891 points.
STOCK PRICES
Stock prices also show areas of support and resistance. In fact, they are a key element in technical analysis and are frequently observed by the fun-
damental analyst. As with indicators, the areas show where buyers or sell-
ers enter the market. In March 2004, Paul Cherney, chief analyst for
Standard & Poor’s, had this to say about the importance of support in his
March 2, 2004 article for Insight from Standard & Poors, “Support Levels
Are Key”:
All the historical studies in the world don’t matter if prices do not move in agreement with them. Even though we are in a period of time when recently there has been a history of positive price action, if price is not moving in the same direction as the tendencies quantified in the studies suggest, then the studies do not matter, only prices matter. The support levels mentioned above appear important because neither the Nasdaq nor the S&P 500 was able to establish a higher high, and that means that if there is a close below those support levels, then a series of lower highs and lower lows will have been established, and that is the definition of a downtrend.
IMPERFECT PREDICTORS
Support and resistance do not really predict or forecast what will happen next. All they do is indicate what happened in the past and could happen again. The anticipation and subsequent actions of buyers and sellers will determine what happens. However, the knowledge of support and resis-
tance can give the investor an indication of what is likely to happen.
The Example of 3M
Take a look at the price action of 3M (Figure 2). Notice how the $60
price level was strong resistance back in 2001 to about April 2002. The
price then shifted up a bracket and the resistance that had been so strong
became support, to July 2003, where the stock rallied all the way up to
$85 a share.
Notice how in July and October 2002 corrections that penetrated the support level tended to fall much further. This is also true of the upside. As resistance is penetrated, a good rally usually ensues.
THEY ARE IMPORTANT
The understanding of resistance and support, both at the broad market level and the individual stock level, are important to seeing what a price is likely to do. Remember that when a support or resistance level is penetrated, more of the same can be expected, usually (but not always) to the next level of support or resistance.
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