One premise of technical analysis is that stock prices are affected by support and resistance. As those terms imply, support acts to keep a stock's price above a certain level, while resistance acts to keep a stock's price below a certain level. In fact, once it has been determined that a price has acted as important support or resistance in the past, it is very likely that a particular price will do so again in the future. Drawing support and resistance lines on stock charts helps determine how significant they were in the past and how significant they might be again. If we find a stock trading toward one of these price levels, we can make some reasonable predictions as to how the stock price might respond. We can then make trading decisions based on this anticipated price action.

What are support and resistance, and why do they occur at definite price levels? What do they look like on price charts? To help answer these questions, we will take a look at the charts of stocks with clearly identifiable support and resistance levels and draw the lines on the charts. Using the information we glean from doing so, we can estimate the probability of these levels acting again as support or resistance when prices approach these levels.

But first, let us define some of these terms and look at what causes the formation of support and resistance.

DEFINITIONS

Anyone who has watched financial news programs on television has probably heard technicians make such comments as "I see support for the Dow at 7300" or "The Dow should experience some resistance at about 8100." So what do these financial pundits mean by support and resistance?

Robert Edwards and John Magee, in their classic work Technical Analysis Of Stock Trends, define support as buying, either actual or potential, in sufficient volume to prevent any further downward movement in prices for an appreciable period. Resistance is the opposite of support; it is selling, either actual or potential, in sufficient volume to satisfy all bids, thereby preventing prices from going any higher for a while. These definitions are quite similar but not identical to the terms demand and supply, respectively.

The term support level refers to the price at which buyers are willing to step in and buy enough shares of stock to temporarily stop or possibly reverse a downtrend. Conversely, a resistance level is the price at which sellers are willing to sell enough shares of stock to temporarily stop and possibly reverse an uptrend. In terms of supply and demand, support is the price level at which the demand for the stock exceeds its supply, and resistance is the price level at which the supply of stock exceeds its demand. An example can be seen in Figure 1.