An essential component of technical analysis is the principle that prices trend. In a trending market, prices continually rise to form an uptrend or continually fall to form a downtrend. However, prices can also move sideways, or oscillate up and down, in a trading market.
In order to confirm that a stock is in an uptrend or downtrend, analysts recommend finding at least three data points to support the trend. The longer the trend is in existence, the more reliable it becomes and the more you can expect prices to continue along the same trajectory.
Uptrend lines have positive slopes and are formed by connecting the lowest price data points on a price chart. These low points act as a level of support. While a security is trading along a particular uptrend, the support level acts as a set of the lowest prices the security is believed to reach over the course of the trend. When levels of support are broken, it could be a signal that the current trend is slowing or that the trend will soon reverse.
Downtrend lines have negative slopes and are formed by connecting the highest data points on a price chart to form a level of resistance. When a security is moving along a downtrend, the level of resistance is thought to represent the highest prices a security will reach over the course of the trend. If resistance is broken, it could be a sign of an impending reversal and that prices may begin to rise.
Prices can also trade sideways when confined between an upper and lower price level. Analysts refer to prices that move this way by saying they are trending within channel lines, which are two parallel lines that represent the lower and upper levels of where the security is trading. The lower line acts as a level of support and the upper line acts as a level of resistance.
In the Zone
Support and resistance are areas on a chart where price action has interacted with a known previous high or low. As with trend lines, the primary emphasis is how often price action interacts with those expected support or resistance levels.
Support levels are areas defined by highs and lows within a stock's trading history. The true definition is an area of congestions or recent lows below the current market price.
As you can see from the horizontal line in the previous graphic, in the past, as the stock fell to approximately $40.00 a share, the stock price would tend to rally off of that price. Areas with a well-defined history of this pattern are characterized as support levels. When an area of support holds, that is considered a bullish sign, and when it fails it is considered bearish.
No one knows in advance which direction the market may go, and therefore we must make some assumptions. Dow Theory indicates that as long as a stock's price is above a support level it should be assumed to remain intact. However, Dow Theory also acknowledges changes in trend and therefore gives you a means of identifying those changes to help you manage risk.
While support is dictated by the recent lows, resistance levels are typically defined by recent highs.
As can be seen here, any time the stock rallied just above $80.00, the price would tend to decline. According to Dow Theory, when price history reveals a resistance level, it is considered to remain intact until broken. A move above a resistance level is considered bullish, while a failure to move above a known resistance level is considered bearish.
It is also importance to understand how support and resistance interact with each other during a trending market.
As a stock moves higher or lower, former resistance levels become support levels. The opposite would be true of a stock that is identified as being in a downtrend. By learning to identify support and resistance levels, you can learn to manage risks by identifying the health of a trend and the likelihood that it might continue or pause.
The strategies described in this article are for information purposes only, and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision. Securities are subject to market fluctuation and may lose value.