This is part 11 of a series on technical analysis; this section is about resistance levels. Click here for the series overview in part one. Click here for part two on the history of technical analysis. Click here for part three on an overview of candlestick charts. Click here for part four on basic candlestick patterns. Click here for part five on advanced candlestick patterns. Click here for part six on Bollinger Bands. Click here for part seven on trend lines. Click here for part eight on Fibonacci retracements. Click here for part nine on moving averages. Click here for part 10 on support levels.
Support and resistance levels go hand in hand in technical analysis. They are like opposite sides of the same coin, and although there are some similarities in how they are interpreted, they aren’t exactly the same. We discussed support levels in the previous article in this series, so now we turn to resistance levels.
What is a resistance level?
A resistance level acts sort of like a ceiling on a security’s price. It’s a key level the price has a difficult time breaking through. A resistance level is formed by a large number of sellers all exiting the security at that particular price. It basically just means that traders are only interested in selling at that price, and not enough investors are buying to push the price above the resistance level.
Many traders will buy a security when the price hits the support level, assuming it will rise from there, and then sell when it hits the resistance level, assuming it will fall back down after hitting that point. Day traders in particular use this strategy to maximize their short-term gains. Support and resistance levels tend to remain in place until some kind of exterior force causes a change. For example, a major event for a company such as an impressive earnings surprise could cause its stock to re-rate higher, re-setting the resistance level higher. Traders become more willing to pay a higher price for that stock because the company is earning more money than previously expected.
In many cases, resistance levels act as a type of psychological barrier because investors just can’t see any reason to pay more than that particular price. Thus, a large number of traders will sell out of the security when it hits that price, while few will buy, causing an area of resistance that keeps the price within the previously identified range.
It’s important to realize that in a downtrend, the previous support level often becomes the new resistance level as the price trends lower. On the other hand, in an uptrend, the resistance level often becomes the new support level as the price breaks through it and continues to rise.
Using resistance levels with other indicators
Resistance levels are generally drawn on a trading chart to connect two or more high points. In the case of a range-bound security, the line is horizontal and connects two or more prices which are very close to the same. The security will appear to hit that price repeatedly but then bounce lower each time. Resistance levels can also be drawn diagonally in an upward or downward trajectory, with each high point being progressively higher or lower than the one just before it.
Just as they are with support lines, trend lines can also be useful when drawing resistance levels. As an asset trends gradually higher or lower, it will repeatedly hit a sort of plateau and enter a period of sideways trading before breaking outside again and resuming the trend. Plateaus occur in an upward trend when a large number of traders decide to lock in the gains they captured. However, the big question with any plateau is whether it is the beginning of a new downtrend or merely a pause ahead of further gains. By studying the trend lines and resistance level, experienced traders can get a good idea of which scenario it might be.
Resistance levels are also used along with other indicators like moving averages. Often a moving average itself will serve as a resistance level. For example, traders may notice that a stock’s price has difficulty rising above its 20-day simple moving average. In this case, the price may rise to the 20-day average and then retreat repeatedly. If the price breaks through the 20-day average, it’s considered a significant move, especially if that average has been tested numerous times and the price failed to pass it. When a moving average is acting as a resistance level, it’s because the price is in a general downtrend.
Considerations when identifying resistance levels
No single technical indicator should be used on its own to predict future price movements. Thus, when deciding whether to adjust a resistance level, it’s a good idea to look at other factors like the volume. If volumes are high when the price breaks above the resistance level, it suggests that level could be about to become the new support level because there is plenty of support for the price that once served as an area of resistance. On the other hand, if volumes are low as the price approaches the resistance, then it suggests that the zone will hold, at least for a while.
Another factor to consider when looking at resistance levels is the number of times the level has been tested. The more times the resistance has been tested, the stronger and more significant it is. Thus, it will take even more buying to break through the resistance. The stronger the resistance, the more difficult it will be for the price to break above it.
The size of the price move just before the point you are looking at is also significant. If the volume is high and the price has climbed fast, it will be more likely to break through the resistance level. On the other hand, in the event of a slow but gradual uptrend, it may be more difficult for the price to break through the resistance. Understanding these factors is important when it comes to interpreting and using resistance levels.
How to use resistance levels
The point of determining resistance levels is to identify points of entry or exit based on past patterns. When it becomes clear that the resistance level has been broken, it might make sense to buy the stock because more upside could be ahead. If the resistance level has just become the new support line, then there was even more reason to buy when it was broken.
Resistance levels are also helpful in identifying prices at which to sell. If you bought the security when it was at the support level, you may want to sell when it nears the resistance level, assuming you have captured all of the gains possible from the move.
On the other hand, resistance levels can also be helpful when shorting a stock. Short-sellers borrow shares assuming the price will fall, so identifying the resistance level will give you a good price at which to short the stock if you’re comfortable betting against it rising beyond the resistance level.