One of the most crucial concepts in technical analysis is 'support' and 'resistance'. Among other reasons for its importance, knowing where support and resistance allows the technical analyst to establish risk and reward for a prospective trade. This in turn lets the trader decide whether open a position is worthwhile.

This is the first portion of a 2-part article explains 'support' and 'resistance' with layman terms and then tells the reader how risk and reward can be defined.

A series of highs and lows

What is support and resistance? Prices move in a series of highs and lows. At the highs, profit taking takes place. Selling by bears and weak bulls puts a supply of scrips in the market. When sellers are unable to find enough buyers to absorb these scrips, they are sold at a discount in order to incentivate buyers who are only willing to pay lower prices. This action causes price to fall.

At the lows, buying interest causes supply of scrips to run out. New sellers 'ask' for higher prices. Buyers have to constantly pay higher prices in order to get the scrips they want.  As a result price is driven up.

Resistance and support

Market participants act according to their memory of the market. For example, a previous high price of Stock X is 1 dollar. Market participants remember that price was unable to exceed 1 dollar and so they begin to take profit at or near 1 dollar again. 1 dollar which was also the previous high becomes now a resistance. 1 dollar will therefore stay as resistance until buying interest becomes very strong to buy up all the scrips lining to sell at that price.

In the opposite direction, 90 cents is the previous low. Whenever price reaches this level, market participants remember that price is likely to rebound. Buying comes in to absorb all the scrips available for sale. 90 cents becomes the support.

1 dollar is probably not the only resistance. This scenario of highs and lows will happen many times as scrips flow between states of strong buying and strong selling.

Illustration

Lets imagine you are on the 5th floor of a 10-storey building. Imagine again that strangely this building has neither stairs nor windows for you to move about. The floor is your support and the ceiling is your resistance. If you want to move up to the 6th storey, you will need to penetrate the ceiling. One or more attempts may be required to break this ceiling before you can go up. However you can only reach the 6th storey because the next ceiling prevents you from reaching the 7th storey.

Similarly, for you to move down you need to break the floor. When you succeed, you will only reach the 4th storey and the floor on this level will prevent you from reaching the third storey.

As you understand by now, price does not travel in a straight line as there will be obstacles in its way. Understanding this will allow the technical analyst to be able to handle the rythm or ebb and flow of price in the market.

Chart of Sembcorp Industries - Prices moves in a series of highs and lows. Buyers and sellers act based on the memory of the levels. Their action creates resistance and support levels.

Look out for Part 2 on May 05 2008 where we will illustrate the calculaton of reward-risk.

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Resistance and support is taught in course Paper And Pencil Series: Practical Technical Analysis (For Novices). 39 Intakes have been conducted for close to 800 students. Not knowing resistance and support is a competitive disadvantage.

For more information, contact (65) 6492 3196 for assistance.