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Investing in the stock market can be a thrilling and lucrative experience. However, it can also be overwhelming for new investors trying to navigate the complex world of stocks. Understanding the concepts of support, resistance, and trendlines can help investors make better-informed trading decisions and minimise risks.
What are Support and Resistance?
Imagine you’re climbing a mountain. As you ascend, you come across a plateau that seems to level off. You take a break, look around, and notice that you can see for miles in every direction. This plateau represents a support level in the stock market.
It’s a point where the price of a stock has been “supported” in the past, meaning that the demand for the stock at that price point has been high enough to prevent it from falling any further.
Now imagine that you continue climbing up the mountain, but eventually, you reach a point where the terrain gets steeper and more complex. You struggle for a while, but eventually, you’re forced to turn back.
This point represents a resistance level in the stock market. It’s a point where the price of a stock has been “resisted” in the past, meaning that the supply of the stock at that price point has been high enough to prevent it from rising any further.
Support and resistance levels are important because they help determine the best times to buy and sell stocks. If a stock’s price is approaching a support level, it might be a good time to buy because there’s a good chance that the demand for the stock will push the price back up.
Conversely, if a stock’s price is approaching a resistance level, it might be a good time to sell because there’s a good chance that the supply of the stock will push the price back down.
Breakouts and Breakdowns
A breakout occurs when a stock’s price moves above a resistance level, indicating that the demand for the stock has overwhelmed the supply. This can be a good time to buy the stock because it’s likely to continue rising as demand continues to outpace supply.
On the other hand, a breakdown occurs when a stock’s price moves below a support level, indicating that the supply of the stock has overwhelmed the demand. This can be a good time to sell the stock because it’s likely to continue falling as supply continues to outpace demand.
Upward Trendline
An upward trendline is a line that connects the lowest points of a stock’s price chart as it rises. This line can be used to identify an uptrend in the stock’s price and can help you determine the best times to buy and sell.
It helps traders identify areas of potential support in an uptrend and can be used to predict where the stock price may bounce back from a correction.
Trend Reversals:
A trend reversal occurs when the direction of the trend changes from up to down or from down to up. This can be identified by the break of a trendline or a significant price movement through support or resistance levels.
Trend reversals can be difficult to predict, but understanding support and resistance levels can help traders identify potential areas of reversal and minimise risks.
This can happen for a variety of reasons, such as changes in the company’s financials or shifts in the overall market conditions. Identifying a trend reversal early can be extremely profitable, as it allows you to buy or sell a stock at a price that’s likely to continue in the opposite direction.
Downward Trendline
A downward trendline is a line that connects the highest points of a stock’s price chart as it falls. This line can be used to identify a downtrend in the stock’s price and can help you determine the best times to sell and avoid losses.
It helps traders identify areas of potential resistance in a downtrend and can be used to predict where the stock price may bounce back from a rally.
How long is a downturn sustainable?
The sustainability of a downturn in the stock market depends on several factors, including the underlying economic conditions, investor sentiment, and government policies. In general, a downturn can last anywhere from a few months to several years.
If the downturn is caused by a temporary shock to the economy, such as a natural disaster or a geopolitical event, it may be relatively short-lived. On the other hand, if the downturn is caused by structural imbalances in the economy, such as high debt levels or a real estate bubble, it may take longer to correct.
Investor sentiment also plays a crucial role in the sustainability of a downturn. If investors remain pessimistic for an extended period, it can prolong the downturn and cause it to become more severe. However, if investors regain confidence and start buying stocks again, it can help to turn the tide and lead to a sustained recovery.
Finally, government policies can also impact the sustainability of a downturn. Central banks can lower interest rates and inject liquidity into the market to help stimulate growth and boost investor confidence. Governments can also implement fiscal policies, such as tax cuts or stimulus spending, to support the economy during a downturn.
However, by monitoring economic conditions, investor sentiment, and government policies, investors can make more informed decisions about when to buy or sell stocks.
Drawing these lines
Identifying and constructing support and resistance lines can be done by following these steps:
Start by looking at the historical price data of the asset you are interested in.
Identify the levels of support and resistance.
Draw a line connecting the levels: Draw a line connecting the highs or lows of each level. This will create a support or resistance line.
Confirm the levels: It is important to confirm the support and resistance levels by looking for multiple instances where the price has bounced off of or struggled to break through the same level. The more times the level has been tested, the stronger the support or resistance level is likely to be.
Adjust the lines as needed: Over time, the support and resistance levels may change as the market conditions change. It is important to adjust the lines to reflect the current market conditions.
It is important to note that support and resistance levels are not exact prices but zones where price movements tend to slow down or reverse. Therefore, it is important to use other technical analysis tools and indicators in conjunction with support and resistance lines to make informed trading decisions.
What are Fibonacci levels?
Fibonacci levels are a series of horizontal lines or levels that are derived from the Fibonacci sequence, a mathematical sequence discovered by an Italian mathematician named Leonardo Fibonacci in the 13th century.
The sequence is a series of numbers where each number is the sum of the two preceding numbers, starting from zero and one. The sequence goes like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on.
In the context of the stock market, Fibonacci levels are used as a technical analysis tool to identify potential levels of support and resistance. Traders use Fibonacci levels to identify price levels where they can enter or exit a trade, as well as to set stop-loss orders.
The most commonly used Fibonacci levels are 23.6%, 38.2%, 50%, 61.8%, and 100%. These levels are drawn by taking the high and low of a price move and dividing the vertical distance by the key Fibonacci ratios.
For example, if a stock price moves from ₹10 to ₹20, the 38.2% Fibonacci retracement level would be calculated by subtracting 38.2% of the price move (₹6.18) from the high (₹20), resulting in a retracement level of ₹13.82.
Fibonacci levels are based on the idea that markets tend to retrace a predictable portion of a move before continuing in the original direction. While Fibonacci levels are not always accurate, they can be a useful tool for traders when used in conjunction with other technical analysis tools and indicators.
Examples of other indicators of support and resistance include:
Moving Averages (MA)
Relative Strength Index (RSI)
Moving Average Convergence Divergence (MACD)
Bollinger Bands
Note: The next chapter will cover an in-depth explanation of each of these indicators.
Key Takeaways
- Support and Resistance (S&R) are price levels indicated on a chart.
- Support is a level below the current market price that shows buying interest, while resistance is a level above the current market price that shows selling interest.
- In order to identify S&R, a trader should draw a horizontal line connecting at least three price action zones that are well-spaced in time.
- The more price action zones the horizontal line connects, the stronger the S&R is.
- Fibonacci retracement should only be used as a confirmation tool, like any other indicator.
FAQs
Support is a price level that suggests the minimum price a stock will reach, after which it will start rising. Resistance is the maximum price a stock will reach, after which it will fall. Knowing these price points helps in planning suitable trading strategies.
Analysts use historical data and trends to predict how high or low a stock’s price may reach. These price points are not permanent. Every time a stock reaches the support or resistance and breaks out from there, a new price level is formed.
Like all other tools, the support and resistance strategy requires a lot of practice. However, the basic strategy is to buy stocks when they hit the support price, as prices will rise from there. Similarly, traders sell stocks when the price hits resistance, as it will start going down after that.
Trading strategies that are always profitable are seldom available. Given the volatility of stocks, no strategy can offer assured profits. But, using support and resistance points as ranges instead of exact price points, can help traders determine the approximate price at which they should buy and sell to make maximum profits.
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