Irrespective of whether you’re investing or trading in the Indian stock market, you need to be aware of certain key concepts like technical analysis. Technical analysis can be defined as a set of techniques that you can use to predict the price movement of an asset. One of the most popular and simplest technical analysis techniques is support and resistance.
Knowing what they are and how they can be used to make trading decisions is key to your success. Here’s a comprehensive guide explaining the concepts of support and resistance and their significance in trading and investment.
To put it simply, resistance can be defined as the level above which an asset’s price refuses to rise. The price of an asset moves primarily due to the forces of demand and supply. If the demand is more than the supply, the price will continue to rise. However, the prices cannot continue to rise forever. There will come a point where the supply overcomes the demand. It is at this point that the asset’s price will stop moving upward and may even come back down. The point where the asset’s price stops moving upward is termed resistance.
The formation of a resistance point in an asset may be due to any number of reasons. For instance, it may be due to high valuations or could be due to the asset price reaching the investors’ target price.
In the case of financial markets, however, there cannot be a particular point of resistance. Instead, resistance usually manifests in the form of a zone or an area. This is due partly because of the unpredictable nature of the stock market.
When an asset reaches its resistance zone, one of two things can happen. Firstly, the price of the asset can go back down due to the huge influx of sellers and dwindling number of buyers. Traders and investors call this ‘testing the resistance level’. Or, the price of the asset could go past the resistance zone due to the presence of more buyers over sellers. Such a phenomenon is usually rare and is termed ‘breaking the resistance level’.
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Now that you’ve gotten an idea of what resistance is, let’s take up a hypothetical example to try and understand it better.
Let’s assume that you’re interested in the stock of Tata Consultancy Services (TCS) Limited. The current share price of the stock is Rs. 3,189. Since you expect the price to rise further shortly, you purchase 100 shares of the company at the current share price.
Now, as you expected the share price rises to about Rs. 3,228. However, right around this time, the price rise slows down considerably and along with it, the number of sellers goes up and the buyers come down. The share price continues to rise a little to Rs. 3,235 but not beyond that. The share price remains stable at this point and refuses to rise any further.
This price range of Rs. 3,228 to Rs. 3,235 is known as the resistance level. Here, one of two things may happen - the share price may fall back down or rise above Rs. 3,235. You can use this information and place a suitable trade right at this point depending on which way the share price goes.
For instance, if the share price falls, you can book profits by selling the 100 shares that you hold. Alternatively, if the share price rises above the resistance level, you can continue to hold the 100 shares or maybe even purchase more till the price touches the next resistance level.
Support is the opposite of resistance. The level beyond which an asset’s price refuses to fall is known as support. If the supply for an asset is more than the demand, the price will fall. However, unless there are significant issues with the asset, its price will stop falling at one point. When that happens, there will usually be an influx of buyers who will overcome the sellers. Here’s where the price of the asset will stop falling and may even bounce back up. This point is what traders and investors term support.
As with resistance, when an asset reaches its support zone, one of two things can happen. The price of the asset can bounce back up due to the huge influx of buyers, which is usually the case. This phenomenon is known as ‘testing the support level’. Alternatively, the price of the asset could fall below the support zone due to the presence of more sellers than buyers. While this is rare, it can still happen. When it does, such a phenomenon is termed ‘breaking the support level’.
With this, you must now know what support is. Let us now take up a hypothetical example to try and understand the concept more clearly.
Now, assume that you wish to purchase the stock of HDFC Life. The current share price of the stock is Rs. 530.90. However, you expect the share price to fall soon. Therefore, you decide to monitor the price movement for a while before deciding to purchase the stock.
As you predicted, the share price falls to about Rs. 500. But then, the rate at which the price fell slows down significantly after the share price touches Rs. 500. By this time, the number of buyers has gone up. The price of HDFC Life’s shares fall further to Rs. 490 and stays steady at this point.
This price range of Rs. 490 to Rs. 500 is termed as the support level. As you’ve already seen before, the price of HDFC Life can either bounce back up from Rs. 490 or fall further to a point below this price. You can place a trade right around this time based on how the stock moves from this support level.
For instance, if the share price falls further, you can short the stock. On the other hand, if the share price bounces back above the support level, you can purchase a few shares of the entity and sell them once the share price touches a resistance level.
The support and resistance levels for any asset is an important technical indicators that you should always take into consideration. Placing trades based on these levels can improve your chances of getting profits. However, relying solely on the support and resistance levels is also inadvisable. Instead, you could use other technical indicators along with these levels to confirm the price movement before entering a trade.
Speaking of trading in the stock market using support and resistance levels, if you don’t have a Demat account already, consider opening one. Motilal Oswal allows you to open a demat account and a trading account for free through a simple online application process. Head over to the official website to apply for one today.