Support and Resistance Levels

Imagine you’re still driving in that new city, and you’ve found yourself on a busy road. After following the traffic for a while, you notice that at certain points, cars slow down or even stop before moving forward again. You realise these spots are where the flow of traffic changes, maybe due to traffic lights or intersections. In the stock market, traders refer to these turning points as support and resistance levels.

Just like how cars stop or slow down at certain points, stock prices tend to pause or reverse at key levels. These points are critical for traders because they help identify when to buy and when to sell stocks.

Let’s dive deeper into the concept of support and resistance levels, how they work, and how you can use them to make better trading decisions.

What Are Support and Resistance Levels?

Support and resistance levels are key price points where a stock's price tends to stop moving in its current direction. Understanding these levels is essential for traders as they provide clear entry and exit points.

1. Support Level: This is the price level at which a stock tends to stop falling. At this point, buyers find the stock attractive and start buying, which supports the price and prevents it from falling further. It’s like a floor that holds the price up.
2. Resistance Level: This is the price level at which a stock tends to stop rising. At this point, sellers find the stock price high enough to take profits, creating resistance to further price increases. Think of it as a ceiling that limits the stock’s upward movement.

Much like traffic slows down or stops at specific intersections, stock prices also tend to pause or reverse at these support and resistance levels.

How Do Support and Resistance Levels Work?

Support and resistance levels work based on market psychology. These levels often form because many traders make decisions around them. For example:

• Support levels form when many buyers enter the market at a specific price, preventing the stock from falling further.
• Resistance levels occur when many sellers believe the stock has reached a price where they can take profits, stopping the price from rising.

When the price reaches these levels, two things can happen:

1. The price reverses: It bounces off the support or resistance and goes back in the opposite direction.
2. The price breaks through: If the buying or selling pressure is strong enough, the price can break through these levels and continue moving in the same direction.

Now, let’s explore how these levels are identified using simple tools.

Identifying Support and Resistance Levels

Just as you’d use landmarks or signs to find your way around in a city, traders use tools to identify support and resistance levels on stock charts. Here are some common methods:

1. Historical Price Movements

One of the simplest ways to identify support and resistance levels is by looking at past price movements. If a stock has consistently bounced off a particular price level, that level becomes a potential support. Similarly, if a stock has repeatedly struggled to move above a certain price, that level becomes resistance.

Image Courtesy: Tradingview

2. Trendlines

A trendline is a tool used to connect multiple price points, either the highs or lows, to identify support and resistance. In an uptrend, the trendline connects the higher lows and acts as a support level. In a downtrend, the trendline connects the lower highs, forming resistance.

Image Courtesy: Tradingview

For example, if you draw a trendline connecting the higher lows of Tata Motors stock, it will show the support level where the price tends to rise after each dip.

3. Moving Averages

A moving average can also act as a dynamic support or resistance level. Stocks often find support at their 50-day moving average during an uptrend or face resistance at the same level during a downtrend. Traders often use this indicator to determine whether a stock will bounce or breakthrough.

Image Courtesy: Tradingview

Example: Tata Motors and Support & Resistance

Let’s continue with Tata Motors' example. Suppose you’ve been observing the stock, and you notice that every time it falls to ₹400, it bounces back up. This tells you that ₹400 is a support level. Buyers find this price attractive and step in to buy, preventing the price from falling further.

On the other hand, you observe that the stock struggles to rise above ₹450. Each time it approaches this level, sellers take profits, and the price falls back down. This ₹450 level acts as resistance, limiting the stock’s upward movement.

Using this information, you can make a smart decision:

• You could buy when the stock price is near ₹400, expecting it to bounce back up.
• You could sell near ₹450, anticipating the resistance to prevent further gains.

These key levels help you manage your trades more effectively, ensuring you don’t buy or sell at the wrong time.

How Traders Use Support and Resistance Levels?

Traders use support and resistance levels in various ways to improve their trading strategies:

1. Buy at Support, Sell at Resistance: Traders often look to buy when a stock is at or near its support level, expecting the price to rise. Similarly, they aim to sell when the price reaches resistance, anticipating that it will fall.

2. Breakouts and Breakdowns: When the price breaks through a support or resistance level, it’s called a breakout (above resistance) or breakdown (below support). These events often signal the start of a new trend. Traders may look to buy on a breakout or sell on a breakdown, riding the momentum of the new trend.

For example, if Tata Motors breaks through the ₹450 resistance level with high volume, traders might see this as a signal to buy, expecting the stock to move higher.

Why Support and Resistance Levels Are Important?

Support and resistance levels provide traders with clear entry and exit points. Instead of guessing when to buy or sell, these levels give a structure to the market’s movements. Much like knowing when to stop or move forward in traffic, understanding these levels can help you navigate the stock market more confidently.

These levels also help traders manage risk by allowing them to set stop-loss orders just below support levels or just above resistance levels. This minimises losses if the market doesn’t behave as expected.

Conclusion

Understanding support and resistance levels is crucial for making informed trading decisions. These levels act as turning points in the market, giving traders a clear roadmap for when to enter or exit a trade. By identifying these levels through tools like trendlines, moving averages, and historical price movements, you can anticipate market behaviour and position yourself for success.

In the next chapter, we will dive into Dow Theory, which lays the foundation for understanding market trends and how they relate to support and resistance. It will deepen your insight into how these key levels form and why markets move the way they do.