The Strength of Support and Resistance
To what extent can you trust and expect support and resistance to work? It depends how solidly they are established by the market. You can gauge this in several ways.
First, you can see how many times the level has been challenged by the price, and caused a rebound. If the level has been tested on several occasions, then it is more reliable than one touch and retreat. It is also easier to identify the levels when the price has been there a few times, which makes your analysis easier. Just look back at the last chart – the support is very easy to see.
Secondly, how long the stock has been trading up to the levels is a sign of the solidity. In the chart above, the stock has been between the support and resistance for several months, which means the levels are more valid than if it had been trading there for a few days.
Next, as you might expect, if there has been heavy volume trading on those levels they are more established than if not. It’s hard to see if that applies to the chart above, as a couple of peaks cause the scale to be hard to read. There is a spike in September which coincides with one of the support reversals.
Another indication of how well the support and resistance levels may prevail is how recently they have been tested. The more recent any activity is, the more likely it is to hold up to further testing.
Finally, it is worth noting that support and resistance are often at round numbers, such as 10, 20, 30, 50, and 100. The Dow Jones Industrial Average frequently stops or hesitates on multiples of 1000. There’s no real technical reason for this, just psychology, the way people think. It’s even more amazing when you consider that the DJIA is made up of 30 different share prices, added together with different weightings. Here’s the chart –
You can see that in 2005 and 2006 the index hit 11000 and bounced off, taking it as a resistance. In July 2008 it became a support for a month, before the financial crisis caused the index to plunge. 10000, 12000 and 13000 also have prices bouncing against them.
How do you use this information? Well, if you want to buy or sell you should avoid placing your orders right at these or similar round numbers. There’s a chance that your order may not be fulfilled. Far better to place your order just before the price reaches the level, and then you are more likely to find that the order goes through. This applies whether you are trying to get into the market or placing a protective stop.
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