Two of the most frequently used words in the technical lingo are supports and resistances. These are the mostly cited to point out the levels where a trade can be entered into or exited or the points at which an investor can purchase a stock or book profits.
What are supports and resistances? Supports are nothing but troughs (reaction lows) from where a downward movement can reverse. The sellers turn tentative at these levels and the buyers have the chance to wrest the advantage here. The reverse is true with resistance, which are previous peaks. The buyers get edgy at these levels and sellers gain more power.
Chart 1 depicts the support levels in a chart. Ashok Leyland halted a serious correction that began in February 2007 at Rs 36. The stock has halted at this level twice since then, in June and again in August, making the zone around Rs 36, a key support level.
Key resistances are marked in chart 2. Note how the stock price reverses from exactly the same level at which the previous peak was formed, on both the occasions marked on the chart. This is not always the case. A 5 per cent leeway can be allowed for the second or third peak/ trough’s formation.
How do these support and resistance levels work? Well, these are important points of reversal in the past. Every time the price nears these levels, the memories of investors go clickety-clack. They say to themselves, “hey, the price turned from here once so it can very well do so again”. That is how these levels prove to be so effective. The human element!
The supports and resistances discussed above pertain to the highest price on a day when a major peak is formed or the lowest price on a day when a significant trough is formed. Other ways in which supports and resistances are derived are with the aid of trend lines, trend channels, Fibonacci retracement levels, moving average lines pattern supports and so on.
If a stock has reversed from a certain price more than once in the past such supports and resistances gain greater credibility. Once a support level has been effectively breached, it turns in to a resistance level for future upward movements. Similarly resistance levels, once crossed emphatically turn in to supports for future downward movements.