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Part 3 - Basics of Support and Resistance Levels

Wednesday 25 July 2012

Very often, you would have heard analysts talking about 'support' and 'resistance' levels being touched by a scrip. The concepts of 'support' and 'resistance' are very simple but extremely important for the purpose of technical analysis. These levels are important for determining turning triggers for price levels and give possible indications about the levels below which a scrip will not normally move, as well the upper levels, which will not be breached. Let us understand the concept of resistance and support by way of a simple example.

Suppose the scrip of BHEL is quoting at say Rs 2,300 for a few weeks. It starts its upward movement and reaches Rs 2,800. From this level, the scrip reverses its direction and again starts moving within the range of Rs 2,300. Again it moves upwards and after reaching levels of Rs 2,800, it starts to come back to the original levels of Rs 2,300. In this example, there is a buying pressure at levels of Rs 2,300, which takes the price to Rs 2800, at which level, the selling starts in the scrip. This brings back the price to its original level where again the buying starts and the price moves upwards again. Here 2,800 is the resistance level, which the scrip finds difficult to breach and 2,300 is the support level where the downward movement of the scrip is halted. The concept of support and resistance can be explained by way of the following figure:


The concept of resistance and support are important for understanding which way the market or the scrip is expected to move. These levels indicate the possible turning point resulting from increased buying or selling pressures at various price levels which cause an upward or downward movement of price levels. If a scrip touches a resistance or support level more than once, it is called a double bottom or double top formation or triple formations where the scrip has touched these levels thrice. These formations are much stronger resistance and support levels and hence, are much more helpful while taking buy or sell decisions. This can be explained by way of the following figure:


Violation of Support levels
If a scrip violates the support level and moves further downwards from these levels, it means that the selling pressure has far exceeded the buying pressure in the scrip. Hence, the price of the scrip would go down further and look for a new support level from which to change direction. Similarly, if the scrip has breached the resistance level, it means that the demand has far exceeded the supply or selling at that level and the price is likely to rise further in pursuit of a new resistance level. These violations, therefore, give good indications of the upward or downward movements of the prices of a scrip and a decision can be taken based on these movements. On the same lines, if double or triple formations are breached, it adds to the strength of the upward or downward movement of these levels. These violations are also called bottom violations or top penetrations and lead to the formation and discovery of new highs and lows for the scrip over a period of time.

Reversal of role
This is an important phenomenon and should be understood carefully. It means that once a support level of a scrip is violated, it could become a resistance level for all future upward movements. Similarly, if resistance level is penetrated, it could reverse roles and become a support level for future downward movements in prices. This scenario of resistance becoming support and support becoming resistance is termed as a reversal of role. It can be explained by way of the following figures



An understanding of the above two figures is important for the purpose of careful analysis of price movements of scrips in real life situations. This helps in taking an informed decision about the price levels, facilitated by a well thought out analysis of resistance, support and reversals, thereof.

Strength of support/resistance level
The strength of support and resistance levels depends on a combination of many factors. The first factor that needs to be taken into account is the time taken to reach the resistance or support level. So, for example, if the scrip has touched the resistance level very fast in a few trading sessions, a small resistance will be able to hold the prices down. If on the other hand, the scrip has fallen sharply over a period of time and then it meets the support level, chances are that the support will be strong enough to hold the price at that level.

The volumes transacted at the support and resistance levels. A higher volume traded means that the scrip will be able to hold on to these levels more strongly. It is also a good indication to study the past pattern of trading in the scrip and whether the scrip is able to break free from the pattern or it follows the same. If the scrip is seen to be following the pattern for a considerable period of time, chances are that the same will be repeated and support and resistance reached at these levels will be quite strong.

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