Investment School. Understanding supports and resistances

It is very common to hear that the price of a stock has bounced back from a ‘support’ or has reversed lower from a ‘resistance’. These two terms — support and resistance — play a significant role in forecasting the direction of the move of a financial asset — be it a stock, index, commodity or currency.

Here, we look at what a support and a resistance means and their significance in the financial market. Let us consider the movement of USD-INR from 2004 (chart given alongside) to illustrate the concept of supports and resistances.

What are they?

Asset prices move in the form of a series of highs and lows. The high point from where the prices reverse lower are termed peaks. The low points from where the prices reverse higher are know as troughs.

Usually, these peaks and troughs, that is the high and the low points, are called the resistance and support points/levels, respectively.

In other words, supports or resistances can be related to the forces of demand and supply in the market. That is, at a support level (troughs/lows), demand exceeds supply and there will be more buyers than sellers.

A resistance, on the other hand, is a level (peaks/highs) or area where there will be more sellers than buyers as supply exceeds demand.

Supports

Technically, a support level has have the potential to halt the fall of an asset price. Since the buyers will overcome the sellers at the support level, there will also be an upward reversal in the asset price from a support.

See line 2 on the chart. The fall in USD-INR from 52 in March 2009 halted around 44 in April 2010. The level of 44 was not letting the USD-INR fall further for more than a year.

This indicates that the number of buyers were dominantly more than the sellers around the level of 44. Subsequently, the USD-INR rose from 44 (July 2011) to 53 (December 2019). Supports are always poised below the current market price.

Resistances

It is the level which will be placed above the current market price.

A resistance will have the potential to stop a rising asset price. This is because of the fact that sellers will be dominating the buying around that resistance level. As a result, the price is likely to decline from the resistance level.

Line 4 around the level of 68.5 on the chart is a resistance. It stopped the up-move in USD-INR that had begun in 2014 from around 58. After hovering around 68.5 for more than two years, USD-INR subsequently fell to 63 by late 2017.

Role reversal

At certain instances, supports and resistances reverse their roles. That is, a level which had served as a support will turn into a resistance in the future, and vice versa. This happens when the asset price surpasses a support or a resistance level significantly.

See 1 (A) and 1 (B) on the chart which is the extension of the resistance line 1. USD-INR, which was facing resistance around 47 since the beginning of 2004, rose past this hurdle in late 2008 to around 52 in March 2009. Since December 2008, the level of 47 (earlier a resistance) was supporting USD-INR against a fall. Similarly, after falling below 47 again, the level of 47 began to again act as a resistance between October 2009 and September 2011 (line 1 (B)).

Psychological levels

Round numbers, more specifically multiples of 10 or 100, are always highlighted significantly — for instance, Sensex crossing 36,000, oil prices touching $100 per barrel, etc.

This is because such round figures are seen as being attractive for the market players from a psychology point of view.

So, these round figures act as key supports or resistances for an asset class and are termed psychological supports or resistances.

Identifying a significant support or a resistance will help in positioning ourselves in the market. That is, when the prices are falling sharply, the presence of a significant support will aid in identifying a good entry point to buy lower. Similarly, a resistance level will help in exiting the market at the right level when the prices are on an up-move.

Supports and resistances also play a significant role in trading. For a trader, it helps to identify a right stop-loss based on the position taken. That is, a trader will prefer placing the stop-loss below a support level on an assumption that prices will reverse higher even if it falls. Similarly, a trader who has taken a short position will prefer placing the stop-loss above the resistance.

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