SUPPORT & RESISTANCE

Simple English words which most of us quite familiar with and indeed, would probably be using it quite often in our daily lives in the markets. But how many of us have really understood the concepts behind these two seemingly obvious words?

We can define Support as " that area below the market where demand will overwhelm the supply" whereas Resistance can be defined as " that area over the market where supply will overcome demand."

Since the play of supply and demand is a constant one - depending on the market cycle that is being described – the market or the stock would be constantly moving between areas of supply into areas of demand and vice versa. Hence one could probably state that the entire chart of a stock would be made up of a series of identifiable areas of support and resistance.

Imagine a stock, which is priced at 50 currently. Some fresh development occurs, which is however known only to a few people. These few people would therefore be the buyers in the stock and would begin absorbing the quantity at 50. They will do so to the extent of their capacity and if this were now larger than the supply available at the price of 50, the prices then would stop moving below 50, as the demand is constant. Or, in other words, 50 become the support. At around the same time, those who are not aware of the development would be selling the stock; some of them possibly short selling. There would also be set of people who are unable to decide whether they should take a stand or not – either on the long side or on the short side.

Let us now say that the buyers have absorbed all the stock that is available at the price of 50 but continue to remain hungry for more. This would then raise the prices, as the demand will drive up the prices. This way the price will move to, say 75. At this price, let’s say that the original buyers unloaded their stake while there were other willing sellers at 75. The double action of existing sellers now being strengthened by other sellers will lead to a situation where the supply suddenly increases. This will halt the advance of the stock. Hence 75 will act as a resistance. Even here there would be some fence sitters that are unable to decide whether to enter the market (either short or long) at the current price of 75.

Since the supply is now higher, the stock price will drop and retrace back, let’s say, all the way to around 50.

Now see who all are around and what the thinking process is:

There are earlier buyers of 50 who sold at 75, turned a neat profit and are now hungry for more.

There are those who had sold short at 50 but are now given the chance to cover after having seen a higher price of 75.

There were the fence sitters that missed buying at 50 saw the price zoom to 75 but now are given another opportunity to buy in.

It can be easily seen that the number of buyers around 50 now has actually increased three folds from the last time that the prices were around this level! Hence the "support" at 50 becomes stronger and succeeds in generating a lot more demand than can be matched by the supply. Prices begin their journey back to up. Let’s say, again, that the prices now reach 75.

Now see who all are around and what the thinking process is:

There are earlier sellers of 75 who covered short at 50, turned a neat profit and are now hungry for more.

There are those who had bought at 75 but are now given the chance to cover after having seen a lower price of 50.

There were the fence sitters that missed selling at 75 saw the price drop to 50 but now are given another opportunity to buy in.

Once again, we find that the number of sellers has increased three folds. Little wonders then, that the prices will form a "resistance " around 75.

How long can this ping-pong match go on?

Until one of the sides gives way.

Continuing the same example as above, lets say the prices once again drop from 75 back to 50, the same scenario as explained earlier exists. But now, suddenly, a new seller emerges who is able to satisfy the tripled demand. What happens? The prices would attempt to move up but meeting with supplies at every rise, it would begin falling off and then move below 50, as there are no more buyers to halt the prices there. As a result, prices slide and let’s say it reaches 25 before finding fresh support. It will then commence on a rise, which, lets say, brings it back to 50.

Now check who is around and what they do:

Earlier buyers who tasted success on two occasions (buying 50 selling 75) are now saddled with a losing position.

All those bears who had sold several times earlier around 50 and never tasted success but now wanting to get into the game once again.

The successful bears who had sold at 50 and covered around 25 and now with another chance to sell.

The fence sitter bears that had missed the last round but are now ready to participate in this one.

The level of 50 – so reliable for the bulls the last time – is now ripe hunting ground for bears!

As the stock nears 50 again, all the above sellers would pitch in and ensure that there is a decline once again.

This gives us a the classic rule of support and resistance:

Supports once penetrated will act as Resistance in the future when the same price level is approached again and vice versa. They have a role reversal characteristic.