As you continue to grow in your trading knowledge base, you’ll start to hear the term “technical analysis” more and more. The term itself sounds so official and maybe even a little intimidating. But I think that’s the point. Wall Street doesn’t want you to think that you can do what they do. But, when you boil it down, all technical analysis means is that you analyze a stock’s price pattern in order to identify trends that can indicate future price movement for you to plan entry and exit points. And support and resistance levels are the most basic form of technical analysis.
And one of the most basic forms of technical analysis is the support and resistance levels of a stock and being able to identify these levels can help you create your trading plan.
What are Support and Resistance Levels?
As a basis for almost every type of technical analysis, Support and Resistance levels can be identified by the highs and lows that a stock reaches over any given period of time. By simply charting a line through the connecting high points will establish the resistance levels, and similar for the low points in order to establish the support levels.
Support levels are reached when the price of a stock drops to a certain level that buyers are drawn into the market and buy the stock in larger quantities than those selling, thus driving the price upward and establishing a support level. Conversely, Resistance levels are formed when a price stock climbs to a certain point and buying starts to dwindle, but sellers pick up causing the price to fall.
Support and Resistance Levels can be either horizontal or diagonal. Let’s take a look at some examples to help clarify.
Horizontal Support Level
The green arrows indicate the support level was met, meaning the price dropped to the specific level of around $0.765. At this point buyers then took over driving the price back up. When charting support levels, it’s important to note that they are always estimates and never exact. That is why you can see the price fall below the support line a few times on the chart.
Diagonal Support Level
Diagonal Support Levels are the same as Horizontal except they follow an upward trending pattern. In the above example, you’ll notice that as the stock climbs, the support level follows suit. Each green arrow shows a point in time on the upward movement that the price dropped to a specific level. This drew buyers into the market, thus pushing the price back up.
Horizontal Resistance Level
The Horizontal Resistance level is created by connecting the high points on the chart. These high points, indicated using the red arrows, signify when the price reached a certain peak that people who own the stock and started selling. Those sell orders outweighed the buyers, which drives the price back down.
Diagonal Resistance Level
The Diagonal Resistance Level is created by connecting the high points on the chart. As you see the highs continue to get higher throughout the day. Upward trending price movement over a long period of time can still have a resistance level. The the red arrows in the chart show where those levels were hit, and sellers took over driving price back down.
How to Use Support and Resistance Levels to Trade
When you apply support and resistance levels to a chart you will start to understand what good entry and exit points are. The support line is generally used to identify a good entry price. The resistance line is generally used to identify a good exit price. However, if you are employing the breakout trading strategy, you will identify a good entry price when resistance is broken. You you can read more about that here.
It’s also important to always have an entry and exit strategy before trading. The use of a Stop-Loss can help protect you should the trend not continue or if a support line is broken.
Let’s look at an example:
Using the above chart using diagonal levels, it’s pretty easy to identify where the profitable entry’s and exits would be. As the stock hits the support level, some traders would use that as an entry. They would also likely set a very tight stop-loss just below the support level. If the stock bounces off support and climbs upward, the resistance level can be a guide on where to sell.
Before you get started make sure you read our Quick Guide To Day Trading!