Why does support and resistance work

Most traders are confident at these levels in the underlying value of the asset, so the volume generally increases more than usual, making it much more difficult for traders to continue driving the price higher or lower.

Unlike the rational economic actors portrayed by financial models, real human traders and investors are emotional, make cognitive errors, and fall back on heuristics or shortcuts.

If people were rational, support and resistance levels wouldn't work in practice! Most inexperienced traders tend to buy or sell assets when the price is at a whole number because they are more likely to feel that a stock is fairly valued at such levels. Because so many orders are placed at the same level, these round numbers tend to act as strong price barriers. Most technical traders incorporate the power of various technical indicators , such as moving averages, to aid in predicting future short-term momentum, but these traders never fully realize the ability these tools have for identifying levels of support and resistance.

As you can see from the chart below, a moving average is a constantly changing line that smooths out past price data while also allowing the trader to identify support and resistance. Notice how the price of the asset finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down.

Traders can use moving averages in a variety of ways, such as to anticipate moves to the upside when price lines cross above a key moving average, or to exit trades when the price drops below a moving average. Regardless of how the moving average is used, it often creates "automatic" support and resistance levels. Most traders will experiment with different time periods in their moving averages so that they can find the one that works best for this specific task.

In technical analysis , many indicators have been developed to identify barriers to future price action. These indicators seem complicated at first, and it often takes practice and experience to use them effectively. Regardless of an indicator's complexity, however, the interpretation of the identified barrier should be consistent to those achieved through simpler methods. The "golden ratio" used in the Fibonacci sequence, and also observed repeatedly in nature and social structure.

The reasoning behind how this indicator calculates the various levels of support and resistance is beyond the scope of this article, but notice in Figure 5 how the identified levels dotted lines are barriers to the short-term direction of the price.

Remember how we used the terms "floor" for support and "ceiling" for resistance? Continuing the house analogy, the security can be viewed as a rubber ball that bounces in a room will hit the floor support and then rebound off the ceiling resistance. A ball that continues to bounce between the floor and the ceiling is similar to a trading instrument that is experiencing price consolidation between support and resistance zones. Now imagine that the ball, in mid-flight, changes to a bowling ball.

This extra force, if applied on the way up, will push the ball through the resistance level; on the way down, it will push the ball through the support level. Either way, extra force, or enthusiasm from either the bulls or bears , is needed to break through the support or resistance.

A previous support level will sometimes become a resistance level when the price attempts to move back up, and conversely, a resistance level will become a support level as the price temporarily falls back. Price charts allow traders and investors to visually identify areas of support and resistance, and they give clues regarding the significance of these price levels. More specifically, they look at:. The more times the price tests a support or resistance area, the more significant the level becomes.

When prices keep bouncing off a support or resistance level, more buyers and sellers notice and will base trading decisions on these levels.

Support and resistance zones are likely to be more significant when they are preceded by steep advances or declines. For example, a fast, steep advance or uptrend will be met with more competition and enthusiasm and may be halted by a more significant resistance level than a slow, steady advance. A slow advance may not attract as much attention. This is a good example of how market psychology drives technical indicators. The more buying and selling that has occurred at a particular price level, the stronger the support or resistance level is likely to be.

Of course, it isn't impossible to program the correct use of these levels. This was just a short introduction to support and resistance lines. If you want to delve deeper into them or have some questions to ask, leave a comment below. Andrea Unger here and I help retail traders to improve their trading, scientifically. I went from being a cog in the machine in a multinational company to the only 4-Time World Trading Champion in a little more than 10 years. I've been a professional trader since and in I became World Champion using just 4 automated trading systems.

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In My Story Read More Trading off support and resistance takes lots of practice. Work on isolating trends, ranges, chart patterns, support, and resistance in a demo account. Then practice taking trades with targets and stop losses. Only once you are profitable for several months with your support and resistance trading method should you consider trading real money.

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Learn about our editorial policies. Reviewed by Gordon Scott. Learn about our Financial Review Board. Using Trendlines. Major and Minor Support and Resistance Levels. Trading Based on Support and Resistance. False Breakouts. In a given financial market, there are typically three types of participants at any given price level:. As the price rises from a support level, the traders who are long are happy and may consider adding to their positions if the price drops back down to the same support level.

The traders who are short in this situation are beginning to question their positions and may buy to cover exit the position to get out at, or near, breakeven if the price reaches the support level again. The traders who did not enter the market previously at this price level may be ready to pounce and go long if the price comes back down to the support level.

In essence, a large number of traders may be eagerly waiting to buy at this level, adding to its strength as an area of support. If all these participants do buy at this level, the price will likely rebound from the support once again.

Price can, however, fall right through the support level. As price continues to drop, traders will quickly realize that the support level is not holding. The long traders may wait for the price to climb back up to the previous support level, which will now act as resistance, to exit their trades in the hopes of limiting their losses.

The short traders are now happy and may consider adding to their positions if the price revisits the price level. Lastly, the traders who did not enter the market yet may go short if the price comes back to the previous support level, in anticipation of prices dropping further.

Again, a large number of traders may be ready to make a move at this level, but now instead of buying, they will be selling. This same behavior can be witnessed in reverse with traders' reactions to resistance levels. These examples illustrate an important technical analysis principle: That which previously acted as support will eventually become resistant. Conversely, levels that formed resistance will act as support, once the price breaks above the resistance level. This can be seen on any chart or any time frame.

Though investors commonly refer to daily charts to determine areas of support and resistance, smaller time frames are also used, especially by short-term traders, to establish these areas. The chart below, for example, indicates the weekly candlestick price chart of Montreal Trucking Company. Support and resistance zones are not only seen at particular prices; they can vary along with upward or downward trendlines. Fear, greed , and herd instinct are terms that crop up when discussing the psychology behind financial markets.

This is because human emotions play a part in the price action observed in markets. A price chart, then, can be thought of as a timeline of optimism and pessimism. Price charts illustrate how market participants react to changing future expectations.

Fear and greed, for example, are seen in the market participants' behavior outlined above. As price falls back to a support level, the traders who are already long will add to positions to make more money.

Meanwhile, the traders who are short will buy to cover, because they are afraid of losing money. Herd instinct is also demonstrated in this example as traders tend to congregate near these support and resistance levels, further strengthening them.