SUPPORTS AND RESISTANCES
1. S&R are price points on the chart
2. Support is a price point below the current market price that indicate
buying interest
3. Resistance is a price point above the current market price that indicate
selling interest
4. To identify S&R, place a horizontal line in such a way that it
connects at least 3 price action zones, well spaced in time. The more number of
price action zones (well spaced in time) the horizontal line connects, the
stronger is S&R
5. S&R can be used to identify targets for the trade. For a long trade,
look for the immediate resistance level as target. For a short trade, look for
the immediate support level as target.
The best way to identify the target price is to identify the
support and the resistance points. The support and resistance (S&R) are
specific price points on a chart which are expected to attract maximum amount
of either buying or selling. The support price is a price at which one can
expect more buyers than sellers. Likewise the resistance price is a price at
which one can expect more sellers than buyers.
On a standalone
basis traders can use S&R to identify trade entry points as well.
The Resistance
As the name suggests, resistance is something which stops the price from
rising further. The resistance level is a price point on the chart where traders
expect maximum supply (in terms of selling) for the stock/index. The
resistance level is always above the current market price.
The likely hood of the price rising up to the resistance level,
consolidating, absorbing all the supply, and then declining is high. The
resistance is one of the critical technical analysis tool which market
participants look at in a rising market. The resistance often acts as a trigger
to sell.
Here is the chart of Ambuja Cements Limited. The horizontal line
coinciding at Rs.215 on chart, marks the resistance level for Ambuja Cements.
I have deliberately compressed the chart to include more data points,
the reasons for which I will shortly explain. But before that there are two
things that you need to pay attention to while looking at the above chart:
1. The resistance level, indicated by a horizontal line, is higher than the
current market price.
2. While the resistance level is at 215, the current candle is at 206.75.
The current candle and its corresponding price level are encircled for your
reference
For a moment let us imagine Ambuja cements at Rs.206 forming a bullish
marubuzo with a low of 202. We know this is a signal to initiate a long trade,
and we also know that the stoploss for this trade is at 202. With the new found
knowledge on resistance, we now know that we can set 215 as a possible target
for this trade!
Why 215 you may wonder? The reasons are simple:-
1. Resistance of 215 implies there is a likelihood of excess supply
2. Excess supply builds selling pressure
3. Selling pressure tends to drag the prices lower
Hence for reasons stated above, when a trader is long he can look at
resistance points to set targets and to set exit points for the trade.
Also, with the identification of the resistance the long trade can now
be completely designed as follows:
Entry – 206, Stoploss – 202, and Target – 215.
The next obvious question is how do we identify the resistance level?
Identifying price points as either a support or resistance is extremely simple.
The identification process is the same for both support and resistance. If the
current market price is below the identified point, it is called a resistance
point; else it is called a support point.
Since the process is the same, let us proceed to understand ‘support’,
and we will follow it up with the procedure to identify S&R.
The Support
Having learnt about resistance, understanding the support level should
be quite simple and intuitive. As the name suggests, the support is something
that prevents the price from falling further. The support level is a price
point on the chart where the trader expects maximum demand (in terms of buying)
coming into the stock/index. Whenever the price falls to the support line, it
is likely to bounce back. The support level is always below the
current market price.
There is a maximum likely hood that the price could fall till the
support, consolidate, absorb all the demand, and then start to move upwards.
The support is one of the critical technical level market participants look for
in a falling market. The support often acts as a trigger to buy.
Here is the chart of Cipla Limited. The horizontal line coinciding at
435 on chart marks the support level for Cipla.
Few things that you need to notice on the chart above:
1. The support level, indicated by the horizontal line is below the current
market price
2. While the support level is at 435, the current candle is at 442.5. The
current candle and its corresponding price level are encircled for your
reference
Like we did while understanding resistance, let us imagine a bearish
pattern formation – perhaps a shooting star at 442 with a high of 446. Clearly
with a shooting star, the call is to short Cipla at 442, with 446 as the
stoploss. Since we know 435 the immediate support, we can set the target at
435.
So what makes Rs.435 target worthy? The following reasons back the
decision:
1. Support at 435 implies there is a maximum likely hood of excess demand
to emerge
2. Excess demand builds buying pressure
3. Buying pressure tends to drag the price higher
Hence for the reasons stated above, when a trader is short, he can look
at support points to set targets and to set exit points for the trade.
Also, with the identification of the support, the short trade is now
completely designed.
Entry – 442, stoploss – 446, and target – 435.
Construction/Drawing of the
Support and Resistance level
Here is a 4 step guide to help you understand how to identify and
construct the support and the resistance line.
Step 1) Load data points –
If the objective is to identify short term S&R load at least 3-6 months of
data points. If you want to identify long term S&R, load at least 12 – 18
months of data points. When you load many data points, the chart looks
compressed. This also explains why the above two charts looks squeezed.
1. Long term S&R – is useful for swing trading
2. Short term S&R – is useful intraday and BTST trades
Here is a chart where I have loaded 12 months of data points
Step 2) Identify at least 3 price action zones – A price action zone can be described as ‘sticky points’ on chart where
the price has displayed at least one of the behaviors:
1. Hesitated to move up further after a brief up move
2. Hesitated to move down further after a brief down move
3. Sharp reversals at particular price point
Here are a series of charts that identifies the above 3 points in the
same order:
In the chart below, the encircled points indicate the price hesitating to
move up further after a brief up move:
In the chart below, the encircled points indicate the price hesitating
to move down further after a brief down move:
In the chart below, the encircled points indicate sharp price reversals:
Step 3) Align the price action zones – When you look at a 12 month chart, it is common to spot many price
action zones. But the trick is to identify at least 3 price action zones that
are at the same price level.
For example here is a chart where two price action zones are identified
but they are not at the same price point.
Look at the following chart, I have encircled 3 price action zones that
are around the same price points:
A very important point to note while identifying these price action
zones is to make sure these price zone are well spaced in time. Meaning, if the
1st price
action zone is identified on 2nd week on May, then it will be meaningful to identify the 2nd price action zone at any point
after 4th week
of May (well spaced in time). The more distance between two price action zones,
the more powerful is the S&R identification.
Step 4) Fit a horizontal line
– Connect the three price action zones with a horizontal line. Based
on where this line fits in with respect to the current market price, it either
becomes a support or resistance.
Have a look at this chart
Starting from left:
1. The 1st circle highlights a price action zone where there is a sharp
reversal of price
2. The 2nd circle highlights a price action zone where price is sticky
3. The 3rd circle highlights a price action zone where there is a sharp
reversal of price
4. The 4th circle highlights a price action zone where price is sticky
5. The 5th circle highlights the current market price of Cipla – 442.5
In the above chart all the 4 price action zones are around the same
price points i.e at 429. Clearly, the horizontal line is below the current
market price of 442.5, thus making 429 as an immediate support price for Cipla.
Please note, whenever you run a visual exercise in Technical Analysis
such as identifying S&R, you run the risk of approximation. Hence always
give room for error. The price level is usually depicted in a range and not at
a single price point. It is actually a zone or an area that acts as support or
resistance.
So going by the above logic, I would be happy to consider a price range
around 426 to 432 as a support region for Cipla. There is no specific rule for
this range, I just subtracted and added 3 points to 429 to get my price range
for support!
Here is another chart, where both S&R have been identified for Ambuja
Cements Limited.
The current price of Ambuja is 204.1, the support is identified at 201
(below current market price), and the resistance at 214 (above current market
price). So if one were to short Ambuja at 204, the target, based on support can
be at 201. Probably this would be a good intraday trade. For a trader going
long at 204, 214 can be a reasonable target expectation based on resistance.
Notice in both the support and the resistance level, there at least 3
price action zone identified at the price level, all of which are well spaced
in time.
11.4 – Reliability of S&R
The support and resistance lines are only indicative of a possible
reversal of prices. They by no means should be taken for as certain. Like
anything else in technical analysis, one should weigh the possibility of an
event occurring (based on patterns) in terms of probability.
For example, based on the chart of Ambuja Cements –
Current Market Price = 204
Resistance = 214
The expectation here is that if at all Ambuja cements starts to move up
it is likely to face a resistance at 214. Meaning, at 214 sellers could emerge
who can potentially drag the prices lower. What is the guarantee that the
sellers would come in at 214? In other words, what is dependence of the
resistance line? Honestly, your guess is as good as mine.
However, historically it can be seen that whenever Ambuja reached 214,
it reacted in a peculiar way leading to the formation of a price action zone.
The comforting factor here is that the price action zone is well spaced in
time. This mean 214 stands as a time tested price action zone.
Therefore keeping the very first rule of technical analysis in perspective
i.e “History tends to repeat itself” we go with the belief
that support and resistance levels will be reasonably honored.
Purely from my personal trading experience well constructed S&R
points are usually well respected.
11.5 – Optimization and checklist
Perhaps, we are now at the most important juncture in this module. We
will start discovering few optimization techniques which will help us identify
high quality trades. Remember, when you seek quality, quantity is always
compromised, but this is a compromise that is worth making. The idea is to
identify quality trading signals as opposed to identifying plenty, but
worthless trades.
Optimization in general is a technique wherein you fine tune a
process for best possible results. The process in this context is about
identifying trades.
Let us go back to candlesticks patterns, maybe to the very first we
learnt – bullish marubuzo. A bullish marubuzo suggests a long trade near the
close of the marubuzo, with the low of the marubuzo acting as the stoploss.
Assume the following credentials for the bullish marubuzo:
Open = 432, High = 449, Low = 430, Close = 448
Hence the entry for the long trade is approximately at 448, with 430 as
the stoploss.
Now what if the low of the marubuzo also coincides with a good time
tested support? Do you see a remarkable confluence of two technical theories
here?
We have a double confirmation to go long. Think about it on following
terms:
1. A recognized candlestick pattern (bullish marubuzo) suggests the trader
to initiate a long trade
2. A support near the stoploss price suggests the trader the presence of
significant buying interest around the low
While dealing with a fairly random environment such as the markets, what
a trader really needs is a well crafted trade setup. The occurrence of the
above two conditions (marubuzo + support near the low) suggests the same action
i.e to initiate a long trade in this case.
This leads us to an important idea. What if we had a checklist (call it
a framework if you like) for every trade that we consider? The checklist would
act as a guiding principle before initiating a trade. The trade should comply
to the conditions specified in the checklist. If it does, we take the trade;
else we just drop it and look for another trade opportunity that complies with
the checklist.
Discipline, they say makes up for the 80% of the trader’s success. The
checklist in my opinion forces you to be disciplined; it helps you avoid taking
abrupt and reckless trading decision.
In fact to begin with we have the first two very important factors of
the checklist:
1. The stock should form a recognizable candlestick pattern
1. Note: We have learnt some of the popular patterns in this module. To
begin with you can use just these patterns to comply with checklist
2. S&R should confirm to the trade. The stoploss price should be around
S&R
1. For a long trade, the low of the pattern should be around the support
2. For a short trade, the high of the pattern should be around the
resistance
Going forward in this module, as and when we learn new TA concepts, we
will build this checklist. But just to quench your curiosity, the final
checklist will have 6 checklist points. In fact when we have the grand 6
checklist points, we will weigh down each one of them. For example, checklist
point number 4 may not be as important as point number 1, but nevertheless it
is more important than 100 other factors that distract the trader.
