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What is Support and Resistance?
The market does not move in a continuous straight line but rather in a zigzag pattern, creating peaks and troughs. Hence, price action results in the formation of various levels which provide a cushion or support when prices fall, or create a ceiling or resistance when prices rise. These levels are appropriately called support and resistance levels. Prices usually bounce off these levels each time to create new peaks and troughs.
What Creates Support and Resistance Levels?
Support is the price level at which demand (buying power) is strong enough to prevent the price from declining further. So when prices fall to a certain level, the prices are cheap enough that it results in many buyers entering the market. This eventually lifts prices higher, causing the market to bounce back up. Resistance is the price level at which supply (selling power) is strong enough to prevent the price from rising further. The logic behind this is that as prices become more expensive, more sellers enter the market to take advantage of these high prices and make a profit. This results in prices eventually falling, until they reach a certain support level.
Note in the diagram above how support and resistance can switch roles. For example, the support level at point A later became a resistance level at point D. Once the first support level is broken, another is created and the previous support level now becomes a resistance level.
Sometimes we do not know whether the support or resistance level was broken permanently and if prices will continue past these levels to create new support or resistance levels. There will be occasions when these levels can be temporarily broken because the market is simply testing those levels.
For example, looking at this chart we can see that prices broke below the support level. At those times it seemed like the market was breaking support. However, in hindsight we can see that the market was merely testing that level.
The more often price tests a level of support or resistance without breaking it, then the stronger the area of resistance or support becomes.
