What are support and resistance?
In finance, support and resistance refer to price levels where an asset has trouble crossing. The support zones are at the bottom of the price chart, while resistance lines are at the top. Whenever an asset reaches a strong support level, demand from buyers outpaces high supply from sellers. But, as an asset approaches resistance, it usually meets with increased sell pressure, curbing upward momentum.
All technical analysts use support and resistance lines, but there's no exact science to determine these price levels. Every trader uses a unique set of tools and metrics to define an asset's support and resistance prices. The support and resistance zones on a daily chart may differ from those on a weekly or monthly chart.
Traders can use support and resistance on any tradeable asset, but they're most often associated with volatile and liquid investments such as stocks, ETFs (exchange-traded funds), and cryptocurrencies. It's also possible to study historical support and resistance levels in assets such as precious metals, commodities, and fiat currencies in the forex market.
How to identify support and resistance
It may seem easy to draw support and resistance lines at the highs and lows of a price chart. But in reality, technical analysts rely on many complex metrics. Although every trader has unique preferences, here are a few crucial features most analysts use:
- Historical highs and lows: The simplest method to locate support and resistance is to look at a long-term price chart and focus on levels where prices bounce. The more often prices hit a "ceiling" or touch a local bottom, the stronger these support and resistance levels are.
- Moving averages: These lines show an asset’s median price over a pre-set length. For instance, the 50-day moving average shows the mid-range price for an asset over the past 50 days. Moving averages such as the 50-day, 100-day, and 200-day often converge with support and resistance lines, and some traders use these to map out long-term price trends.
- Round numbers: Most assets face steep resistance or find reliable support when approaching round numbers. Prices such as $50, $100, or $1,000 are potent psychological zones that usually translate to support and resistance prices.
- Average volume: Volume measures how much of an asset traded hands on an exchange during daily sessions. If buying volume spikes at the low end of a price chart, it may signal a substantial area of support. Conversely, if sell volume accelerates as an asset rises in volume, it may indicate resistance.
- Relative strength index (RSI): The RSI helps analysts gauge how quickly an asset’s price changed relative to its supply. Traditionally, a high RSI score suggests a price is unsustainably high, but low RSI scores suggest an asset is oversold. Therefore, high RSI readings may indicate resistance, and low numbers may depict support.
- Fibonacci retracement levels: Named after the mathematician Leonardo Fibonacci, "Fibonacci levels" are a set of percentages traders use to predict future price movements. These horizontal zones are 23.6%, 38.2%, 61.8%, and 78.6% above or below an asset's current price. While there's debate over the reliability of these percentages, many traders use them when researching support and resistance.
Why do traders use support and resistance?
Support and resistance levels make it easier for traders to calculate their risk when setting up a short-term strategy. A trader may set up a support and resistance indicator to get an email alert whenever a stock or crypto hits their desired price. Traders can also set limit orders at support and resistance levels when making a trade. Since a limit order automatically activates whenever an asset hits its target price, they guarantee a trader will lose or gain a specific amount of money.
For example, Apple stock (AAPL) traded between $138 and $174 per share for most of 2022. Using this info, a technical trader may set a limit order to buy one AAPL share at $139. If this order triggers, the trader can set up two more limit orders to sell a share for $136 or $170. This strategy is called an OCO order (One-Cancels-the-Other order) because the first limit order of AAPL’s price “cancels” the other one. Here, the trader can only lose $3 per share if AAPL breaks support and falls to $136. However, they can also gain $31 per share if AAPL eventually climbs back to its resistance level.
Support and resistance are significant for traders who use high-risk practices such as leverage or naked short selling. While leverage involves borrowing funds from an exchange to artificially increase the position size, naked shorting means selling shares in a company without holding or borrowing stock.
Besides defining a trader's risk-to-reward ratio, support and resistance lines may reveal long-term trends. For example, if a stock finds support at higher lows in a stair-step pattern, it may indicate the company is on a long-term uptrend. However, if a stock meets resistance at lower levels on a monthly chart, it may suggest a downtrend.
What is a support and resistance reversal?
Support and resistance represent zones where buyers or sellers usually step in, but it doesn't mean prices can't break these levels. Whenever an asset's price moves below support or above resistance, it enters a reversal. In these cases, what was support becomes the new resistance zone or vice versa.
For instance, if AAPL shares fell below the $138 support level, $138 would become the new resistance. But, if AAPL traded above the $174 resistance, $174 would become the new support price.
How do support and resistance work in crypto?
Since cryptocurrencies such as Bitcoin are volatile, crypto traders rely heavily on technical tools such as support and resistance. Similar to analyzing stock prices, a trader will look at multiple charts of their favorite coins and draw lines where they see crypto resistance and support zones. Crypto traders can also use tools such as moving averages and Fibonacci extensions to develop their trading strategy.
Although support and resistance can help traders define attractive entry and exit levels, these prices aren't as stable as those in established assets such as blue-chip stocks or precious metals. The crypto market cap is far lower than other asset classes. In mid-2022, the cryptocurrency industry’s total market cap was around $1 trillion, while the market cap for gold was $11 trillion. Some blue-chip tech companies, such as Apple, have market caps of more than $2 trillion.
Although digital currencies such as Bitcoin and Ethereum have grown significantly, they aren't as large as many traditional investments. It takes less money to move the prices of digital assets, which translates to more volatile price action. Until cryptocurrencies become more mainstream, they’re more likely to break support and resistance lines than traditional assets.
Long-term investors typically don't bother researching stock or crypto resistance levels. However, these prices often play a central role in day-to-day trading. Many hedge funds and institutional traders rely on support and resistance prices to set up their trades. Technical analysis may not be an exact science, but it can help explain the seemingly erratic prices in many markets.
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