Most traders use support and resistance levels to determine buy and sell signals, but have traders question the significance of these levels? Technical analysts believe strongly that traders and investors have price memories affecting them when they make trades. For example, they will remember the highest price of the stock they traded have reached. The memory will be stronger if there are emotions attached to it. If the trader had not sold the stocks at its high, he will be disappointed and will want to get even with the market. He is then inclined to hold on and sell when the stock price went back the ‘high’ that he remembered. This makes the price high the resistance level that we are talking about. – it becomes a price where many people will let go of their stocks. The vice versa happens at the support level. As the stock goes up, many traders will deem it expensive and they last remembered the price when it was ‘cheap’. They are unwilling to buy now but will invest if the price goes back to the ‘cheap’ price. Hence, if the stock price reach this level, many trades tend to go through and price becomes stagnant at this level.
How to benefit from support and resistance level?
There are 2 methods to trade support and resistance levels.
1) Mean Reversion
Think of the support as the floor and the resistance as the ceiling. When a ball hits the floor, it will bounce up. When the ball hits the ceiling, it will come down. In the stock market, these situations happens majority of the time. However, it DOES NOT HAPPEN ALL THE TIME like the natural world. A trader must always put a stop loss on every trade he makes so that he does not get punished heavily when he is wrong. In this method, a typical stop loss can be set just above the resistance level if you are shorting, or just below the support level if you are longing.
2) Breakout
As mentioned above that the method does not happen most of the time, and when the stock price fails to bounce away from the support or resistance level, it will actually break further away. The trader who uses this method will buy when the stock price exceeds the resistance level and sell when the price goes below the support level. Usually, stocks that break away from these resistance level, have momentum to go further and will be very profitable to the trader. However, there are false breakouts where the stock price can bounce back after a breakout. This happens when there isn’t enough volume to sustain the run. Hence, a trader that uses this method must still cut loss.
Strength of support and resistance level
Dr Alexander Elder, stated 3 factors that determine the strength of support and resistance levels in his book, “Trading for a Living”.
1) The longer the support/resistance level, the stronger it is – a 2-year support/resistance level is stronger than a 2-month support/resistance level which in turn is stronger than a 2-week support/resistance level. In addition, if the level is being hit and rebounded frequently, it forms a very strong support/resistance level. However, one must watch out whether the support/resistance levels still hold after a considerable period of time. Remember that these levels work only when investors still have these price memories. If the general price memories have been eroded as time passes, these levels may be broken easily.
2) The taller the support and resistance zone, the stronger it is – This means that the support/resistance levels that are very far from the current price are stronger than those levels that are nearer. A level that deviates 1% from the current price is weak; a level that deviates 3% from the current price has moderate strength while a level that deviates 7% from current price is a strong support/resistance.
3) The greater the trading volume in a support and resistance zone, the stronger it is - Strong volume in these levels suggest that the price memories of investors are very strong and many are willing to transact at these prices.
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