Support and Resistance in the Market

April 20, 2009

Ever since trading began, investors have worried over and tried to analyze the factors that drive the stock market. What makes the market move?

Ever since trading began, investors have worried over and tried to analyze the factors that drive the stock market. What makes the market move? There is no one answer as to what causes the sudden erratic swings upward or plunging drops that we’ve seen lately. However, there are some factors that are known to have a positive or negative impact on the market, both on a daily basis and over a longer period of time.

Daily stock movements are mainly based on the laws of supply and demand. As demand grows, the value of a stock goes up and the supply decreases. Conversely, if there is little demand for a stock, the price decreases as the supply of that unwanted stock grows larger.

This movement of a stock can be seen on a chart or graph and learning to understand the direction it is taking, sometimes called a trend line, can become a very helpful tool. The stock climbs and its price increases until it hits a ceiling. This is called the level of resistance when the stock does not advance upward any further. The stock may hit a plateau and then the trend line may slowly start to head downward.

At the lower level, the stocks price falls but then a support level forms beyond which the stock does not go. Following trend lines on a stock chart can help you gauge the overall direction of a given equity and help you identify the levels beyond which the price will have difficulty moving. This information can be very helpful in gauging strategic entry times and also help manage risk by identifying areas to place stop loss orders.

Technical traders pay very close attention to a stock when the price approaches a trend line because these two areas often play a major part in determining the short term direction of its price. As the price of a stock nears a resistance level, it can bounce off and hold at a plateau or it can move through the line of resistance, indicating a new upward trend in price and possible growth. On the other hand, the price may be headed downward toward the support level. If it drops further, through the support level, this indicates a deepening downtrend.

To simplify it, trend lines are simply lines that connect a series of prices to give you a better idea of where your investment is headed. You can make a chart to record this movement, just as a patient’s temperature graph records his progress. First, decide which price you are going to use consistently when you are comparing your investment’s price movement. There is no hard and fast rule about this — just be consistent and know what prices you are comparing. You can use a stock’s:

• Opening price

• Closing price

• Low price

• High price

No two traders will always agree to use the same points of comparison. Some will only compare closing points while others may choose to use a mix of close, open and high prices.

It is important to note that the more the prices touch the trend line, the stronger and more influential that line is believed to be. An upward sloping trend line can show prices that are acting as support levels while the price is moving upward. These supports can also connect different closing prices or period lows. On the other hand, a downward sloping trend line connects a series of closing prices or period highs that were resistance levels that the stock could not break through and is now drifting downward.

Stock market expert, Richard Wyckoff warns that you cannot expect the market to behave exactly the same way twice. He likens the market to an artist with a repertoire of basic behavior patterns that it modifies, combines, and unexpectedly springs on its audience. Wyckoff says a market “is an entity with a mind of its own”. As you learn to read trend lines, this will help you put the movement of an individual stock in perspective.

Michael Doran is Managing Director of the long/short equity fund, Emerald Bay Partners LP. Mr. Doran can be reached at (530) 677-1635 or SLIM® and variations are marks of Investor’s Business Daily, Inc. and affiliates (‘IBD’). The CAN SLIM® Certified mark is licensed by IBD only to signify successful completion of IBD’s CAN SLIM® Training program. IBD does not license, review or approve of, and is not responsible or liable for any investment advice or other services provided by the user. The user is not an agent of, sponsored by, affiliated with, or owned by IBD and is not authorized by IBD to make any representations, warranties, or promises.