Let’s start by looking at what exactly we mean by Technical Analysis, or T/A, as the experts call it. T/A is all about charts and patterns that make people believe certain outcomes are likely to happen. It’s important to remember that markets are driven by people, and if enough people believe something is about to happen, then it will – this is considered a self-fulfilling prophecy!
Technical analysts believe that everything you need to know about a stock’s future activity is contained in the history of its price.
In T/A, Support and Resistance form the basis on which many traders will enter and exit trades, and is extremely important for making profit targets and cutting losing trades.
You can spot support and resistance lines easily on a graph by looking for the points at which a price has changed direction. If the price hits a certain point and reverses more than three times, then it becomes a support or resistance line. The more a certain point is tested, the more important it becomes – but why do investors change their minds at these points?
Support = more buyers than sellers.
A support line is a point at which the demand from buyers is high enough to overwhelm sellers and stop prices falling further. After a decline, the buyers now believe that the share is cheap enough to buy again. On the other side of the equation, the sellers also believe prices won’t go any lower so they close their short positions with a buy order, pushing prices up.
Resistance = more sellers than buyers.
Resistance lines are the exact opposite of support, where sellers believe the stock is too expensive and open enough short positions to reverse the direction of the stock downwards. Conversely, those who bought in earlier at lower prices believe the uptrend is over and close their long positions with a sell order, pushing prices down.
A common strategy is to buy at support and sell at resistance when you believe that a price will reverse. A continuation through support or resistance is called a breakout (shown below).
It is useful to note that a breakout will cause a resistance line to turn into support and vice versa. The graph above shows a breakout through resistance that becomes support as price comes back down to retest the new support level before continuing upward. Traders will often look to enter a trade once a breakout has been confirmed or when prices return to retest the new support.
In terms of knowing when to cut a losing trade, breakouts often confirm a trend direction (up/down) which is a useful way to tell if your trade has failed. In the example above, if you had gone short at the second arrow at the top you would know to cut your loss once the price had broken resistance and become support at the far right arrow where price had confirmed an uptrend.
Now you know the basics, it’s time to get out there and put your newfound T/A skills to good use!