Understanding Technical Analysis: Support and Resistance

What is it that drives prices in the markets? Is it intrinsic value? The present value of future cash flows, the pace of earnings acceleration, dividend and buyback policies? Is it economic growth, interest rates, or manufacturing activity?

Each of these plays an important role in building an investment outlook, but the truth is, they don’t make prices move. Not directly. The reality is more simple than that. Prices move based on changes in supply and demand, or put another way, on peoples’ decisions to buy or sell securities.

People do their best to incorporate all those important, fundamental components into their buy/sell decisions, but human behavior is a funny thing. We’re susceptible to psychological flaws, and even when we know those flaws exist, we’re not good at correcting them.

Over long enough time horizons, asset prices do tend reflect their intrinsic values. If you overlay the S&P 500 index with its annual earnings per share over the long term, you’d be hard pressed to tell which was which. The logical thing, then, would be for humans to make buy or sell decisions solely upon the intrinsic value of an asset. And people know that’s what they’re supposed to do – there are a million books written about the subject. But people don’t do what they’re supposed to do. Emotions get in the way. There are plenty of books written about that, too.

Technical analysis, at its core, is really a study of human behavior. And human behavior reacts to prices it remembers by buying or selling. That’s the foundation of what technicians call ‘support’ and ‘resistance’.

Imagine you just received a hot tip from a friend to buy a stock – the greatest stock you’ve ever heard of, and it’s just getting started! The price passed $150, and your friend assures you it’s headed much higher. Ever the skeptic, you pass on the opportunity. But then the stock goes keeps going, just like your friend said it would.

You’re kicking yourself, right? If only you’d listened to your friend! Not only have you missed the chance to profit, but now you have to deal with his gloating, too.

Then fate intervenes. By some act of an altruistic God, the stock drops back to $150. You can’t miss this opportunity again. So you buy the stock. Your buying, and the buying of everyone else that’s experiencing the same emotions, help demand overcome supply at that price. Your buying is what technicians call ‘support’.

Meanwhile, your friend is frustrated. He staked his reputation on this stock, recommended it to all his friends and family, but then the price collapsed to $150. His paper profits have all but disappeared. If only he’d sold when the price was $200!

Some time passes, and lo and behold, the stock rises back to $200. Your friend jumps at the opportunity and sells everything he has, happy to have locked in his gains. His selling helps supply of the stock overwhelm the demand. In other words, he’s creating ‘resistance’.

Of course, levels of support and resistance are often broken. If they weren’t, no asset would ever rise or fall in a material way, and prices would always be rangebound. That doesn’t mean we should ignore those former levels of support or resistance once they’re broken, though. They’ll potentially be useful again, thanks to the principle of ‘polarity’. Let’s continue with the story:

Your friend watches in satisfaction as the price drops once again following his decision to sell. But after a few months, the stock starts to rally. He watches as it climbs further and further, past $200, all the way to $250! “You fool,” he thinks. “Why did you ever get out?? You’d be making even more money by now.” On top of that, he now has to deal with your gloating. After all, it was his idea to buy the stock in the first place. If he’d just stuck to his own advice, he’d be rolling in profits, just like you.

After some time, though, the rally peters out. The high-flying stock falls right back to earth. Your friend, who remains bitter about his decision to sell, one day looks up and sees the price is $200 once again. This is his chance to right his wrong! It’ll be like he never sold in the first place – he buys the stock back for exactly the same price as he got out. Demand again overwhelms supply, and the $200 level that used to be resistance has now become support. That’s the principle of ‘polarity’.

It’s not like every investor has a friend handing out stock tips, causing us all to react the same way at each price level. But the feelings that are created by price changes are mirrored across humanity, and feelings drive decisions.

That’s why support and resistance work, and that’s why the study of human behavior is every bit as important as building economic and financial models.

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