Support and resistance levels are two key concepts that represent the relationship between supply and demand.
In financial markets, prices depend on changes in supply and demand. When supply increases, there is a downward trend, with expectations of lower prices and more selling. When demand increases, there is an upward trend, with expectations of higher prices and more buying.
These terms are used with similar meanings: when demand rises, prices tend to rise; when supply rises, prices tend to fall. When supply and demand reach equilibrium, prices stabilize.
What is a Support Level?
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A support level is the price level at which demand is believed to be strong enough to prevent the price from falling significantly. When prices fall to the support level or lower, buyers tend to purchase more, while sellers become reluctant to sell.
Before prices reach the support level, demand tends to exceed supply, which prevents the price from dropping below this level.
However, support levels are not always fixed. A drop in the support level signals that supply is outpacing demand. At that point, market participants tend to sell more than they buy. If the support level is broken and a new, lower support is established, it indicates that sellers are losing confidence and are willing to sell at lower prices.
In addition, buyers will often wait to purchase until prices fall below the previous support level. When the support is broken, a new, lower support level is eventually formed.
How Are Support Levels Established?
A support level is typically set below the current market price, and it is generally considered safe to trade near or at the support level. However, technical analysis is not an exact science, and determining an accurate support level can be challenging.
Moreover, price movements can be sudden and drop below support unexpectedly. Sometimes, it is not reasonable to consider support broken if the price falls by only about one-eighth below the support level. For this reason, many traders and investors create a support zone rather than relying on a single price point.
What is a Resistance Level?
A resistance level is the price level at which selling pressure is believed to be strong enough to prevent the price from rising sharply. When prices rise to the resistance level, sellers tend to sell more, and buyers typically stop buying. Before prices reach the resistance level, supply tends to exceed demand, preventing prices from rising above this level.
Resistance levels are also not permanent. When resistance is broken, it signals that demand is outpacing supply.
Breaking a resistance level shows that buyers are purchasing more than sellers are selling. If the resistance is broken and a new, higher resistance level is established, it indicates that buyers are willing to buy even at higher prices.
Furthermore, sellers often wait to sell until prices rise above the resistance or exceed previous highs. When resistance is broken, a new, higher resistance level is eventually formed.
How Are Resistance Levels Established?
A resistance level is typically set above the current market price, and it is generally considered safe to trade at or near the resistance level.
Additionally, price movements can be sudden and rise above resistance unexpectedly. Sometimes, it is unreasonable to assume resistance is broken if the price rises by only about one-eighth above the established resistance level. For this reason, many traders and investors often create a resistance zone instead of depending on a single price point.