December 25, 2009, Newsletter Issue #137: What is Support & Resistance?

Tip of the Week

One of the most basic concepts of technical analysis is support and resistance. Key points below the current price are known as support, and those above the current price are resistance. For example, if a stock falls to a level where enough buyers find it worthwhile to enter (and few potential sellers care to exit), the stock price will reverse upward, marking a point of support. Trendlines extending out from important peaks and valleys can also act as support and resistance. Option activity also plays a role in support and resistance levels at round-number strike prices. For example, if there is a great deal of put open interest at the 70 strike of XYZ Company (XYZ), 70 could mark important support. The reason large put open interest often serves as support stems from the fact that market participants who sold put options and have not hedged their positions will buy XYZ shares to keep the stock above the strike price, preventing the option from expiring in the money. The opposite is also true for large amounts of call open interest. In addition, when small speculators gravitate to a particular strike, they are very often incorrect and that option will likely finish out of the money. Various moving averages often serve as support and resistance. A 20-day moving average, for example, is simply the average of the 20 previous day´s closes. The trendline formed as this 20-day average moves forward through time is often a juncture at which support or resistance can be found. Moving averages work very well when the security is trending higher or lower for a period of time, but not so well when the security moves sideways (contained in a trading range).

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