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June
2006
In this third of a series of articles
focusing on Technical Analysis and the indicators most widely recognized
by technicians, we are going to focus on "support and resistance."
The price action of a security over a period of time will create strength
at certain price levels. These levels are known as "resistance" at
the higher end of the trading range and "support" at the lower
end. A trading range may take anywhere from a few months to a year or
more to develop. This usually depends on the range the technician is
examining.
For our example, we will look at Air Canada stock. Towards the end of
the last decade, Air Canada stock traded in a very narrow range from
$5.00 on the low side to $7.00 on the high side, creating what we call
support at $5.00 and resistance at $7.00. There was enormous support
at the lower end because, over a long period, hundreds of thousands of
shares had changed hands at or around the five dollar mark, thus creating
a very strong support level or "floor". Simply put, it would
require an extraordinary increase in selling activity for the price to
fall below the $5.00 mark. Conversely, trading activity at the higher
price during those several years remained at $7.00 — the stock
price could not seem to break through this barrier. For an unknown reason,
the sellers would outnumber the buyers every time the Air Canada stock
price climbed to the $7.00 range. This "ceiling" or resistance
created an interesting play for traders who recognized the trading pattern.
They would buy the stock as it neared the $5.00 mark and then sell it
(and even go short) a few months later when it began to approach the
$7.00 range. This awarded them with some very healthy profits.
As the price of a security breaks through the resistance level and moves
to higher ground, the level of resistance then becomes the level of support.
A new level of resistance will then be formed at some point in the future.
On the flip side, as the price range falls below the support level, that
level then becomes the new resistance mark.
Understanding the concepts of trending and trendlines is important when
learning about support and resistance. During a market trending to the
upside, resistance levels are formed as the price action slows for an
extended period of time. Pauses in the market often result from profit-taking
or near term uncertainty for a particular issue or sector. The resulting
price action undergoes a "plateau" effect or slight drop-off
in stock price, creating an area of resistance. As a market falls into
a downtrend, the opposite occurs, creating levels of support.
Volume and time are important factors in the development of both support
and resistance. The strongest areas of support and resistance are those
that have developed over an extended period of time, in which large amounts
of shares are traded. For an issue that has traded at the $10.00 level
for 5 trading days, for instance, the price level is not nearly as substantial
as that of an issue that has traded in the same range for a number of
weeks. Volume, or the number of shares traded, also plays an important
role in support and resistance levels. Heavier volume naturally creates
a much stronger level of support or resistance. Investors would have
an easier time breaking through a two-week resistance of a million shares
than a two-week resistance of the same issue trading 20 million shares.
The following chart shows support and resistance for General Electric.
For the most part, GE traded between the $42 and $53 range over the past
year. The lower end of this range is the support, while the high end
is an area of resistance.
In conclusion, support and resistance are key technical indicators that
not only display strength and weakness in an issue but also act as buy
and sell indicators when the price action moves above and below the recognized
floors and ceilings.
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