What is a resistance level?

Posted on Friday, April 12th, 2019 MarketBeat Staff

Summary - Successful trading requires an accurate understanding of where a price is moving, not where it is at the moment. Traders look to technical analysis and the principle of support and resistance to help guide their trading decisions. When a stock is trading in a channel or a range, the price movement can be thought of like a tennis ball that bounces smoothly between two surfaces. The bottom surface represents a "floor" and the upper surface represents a "ceiling". As the price hits the bottom surface it will not drop further and will instead bounce upwards until it hits the upper surface where it meets resistance. This resistance level can stay in place for a short period of time of it can be in place for a long time depending on several factors including news surrounding the stock or broader market dynamics. 

Traders like to find resistance levels because they indicate key levels at which a price will either have to go down, creating an opportunity to exit a long position or enter a short position, or there will be a price break to the upside which can create profitable trading opportunities as what was once the resistance level now provides the support for the next leg higher. Resistance levels are usually thought of as being more significant when they have been tested many times and over a long period of time, when they are accompanied by high trading volume and when they are preceded by a sharp price movement in either direction.

A resistance level is an easily understandable concept but can become less reliable when there is a dynamic price movement. To help identify resistance levels when prices are not range bound, traders can use other technical indicators such as trendlines and moving averages to clarify points of resistance.

Introduction

Technical analysis presumes that market forces are factored into a price at any given moment. Practitioners of “trend trading” believe that the key to profitable trades is an understanding of where the market is moving. To analyze current trends (and predict future ones) analysts have a number of tools at their disposal including trendlines and moving averages. However, an additional concept is that of support and resistance. This concept examines price movement and more importantly the specific price points that define a range of price movement.

The price point at which prices tend to climb to, but cannot advance past, is known as the resistance level. The resistance level is the focus of this article. We’ll take a close look at what a resistance level is, why it is significant and what conditions make a resistance level more significant than another. We’ll also review how to use resistance levels to make profitable trades.

What is a resistance level?

An asset’s resistance level is the price point at which its rise in price is slowed, or reversed when the volume of sellers increases. A resistance point gives investors a reference point for entering or exiting a trade. For example, if over a period of time, the stock of the ABC Company rises, but fails to exceed $41 per share, then a trader may use a price slightly below $41 as a signal to exit their trade (if they are taking a long position) or enter a trade (if they are looking to take a short position).

Resistance levels change when, for example, some new news is released that encourages more buyers to enter the market for that asset. Resistance levels can be short term or long term. Generally speaking, a resistance level that is longer in duration acts as a stronger trading signal for long-term investors. However, day traders and other active traders will look for actively traded assets that may display short-term changes in their resistance levels.

The complement to a resistance level is a support level. A support level is the price at which a stock generates interest from a sufficient number of buyers to cause a price spike.

Why is a resistance level significant?

As technical indicators go, a resistance level takes some of the ambiguity out of trading. That’s because when a price reaches a resistance level, it can only do one of two things: break through it, which indicates increased buying interest in the asset, or bounce off the high and go down in price. From a trading standpoint, knowing an asset’s level of resistance can help take the emotion out of trading decisions because investors will quickly be able to determine if a trade based on a resistance level is going the way they planned.  

When a resistance level is breached, it is an indication that buyers are providing extra force, or enthusiasm, causing prices to surge. The stronger the breakout the more likely it is to represent a new trend. In some cases, fundamental analysis may dictate price movement. For example, a price may move past a resistance level as a result of a positive earnings report or favorable economic reports that relate to the asset. For example, if interest rates are declining, gold and other precious metals may increase because of the inverse relationship between precious metals and fiat currency. Similarly, declining unemployment typically triggers higher crude oil prices as it is expected that there will be more demand for gasoline.

However, in addition to looking at fundamental analysis, there are a variety of technical indicators that can help traders assess the significance of a resistance level.

  • How many times has the resistance level been tested? This is known as a retracement. The more times an asset's price hits a retracement level, the more convicted buyers and sellers will become in basing their trading decisions on those levels.
  • Has there been sharp (or steep) price movement ahead of the resistance level? A sharply advancing asset may draw more competition and attention which may lead to a more defined and significant resistance level.
  • What is the trading volume at the resistance level? The more active the buying and selling at the resistance point, the stronger the level tends to be.
  • How long has the resistance level been in place? If the resistance level holds up over time, it is usually considered to be more significant.

Trading based on a resistance level

As we noted above, a resistance level can give traders a clear entry and exit point for trading. Two ways investors may use resistance levels are to identify when to exit a long position or when to enter a short position.

To walk through each of these scenarios we’ll use an example of Company XYZ whose stock is showing resistance at a current price of $50.

Using a resistance level to exit a long position - As the stock approaches $50, one trader may execute a sell order with the expectation that the stock will fall. This will allow them to collect the profit from the price level where they purchased the stock (most likely near a support level). If the stock does what the trader expects, the trader may continue to monitor the stock chart for a new buying opportunity. If the stock breaches the $50 mark, and it is not just a false breakout, the trader will have forfeited the additional profit that could have been gained and have to make a decision on whether to buy at the higher level in anticipation of a further move up, or perhaps use the previous resistance line of $50 as a new support line.

Using a resistance level to enter a short position– On the face of it, using a resistance level to take a short position is a very logical trading strategy. A clearly defined level of resistance limits upside risk because it implies that there should be selling pressure and provides a signal to traders and investors of what price point to initiate the trade. And if the stock breaks through the resistance point, a trader will see that price action immediately and can exit the position. For example, if in our example of the XYZ Company, the trader attempted to short the stock when it hit $50 and the stock moved down as expected, the trader would win that trade. However, what would happen if the stock dipped momentarily and then the price rises higher. This is where shorting a stock can be very risky because there is theoretically no limit to how far the stock could rise. In this case, the investor would be better off quickly exiting the position. In many cases, they will set a stop loss at a level just above $50 that would minimize their loss. 

Trades who are looking to take a short position can use the following guidelines to increase their probability of success:

  1. Look for an asset that is priced below its 200-day moving average
  2. Look for an asset that is priced below its 30-day moving average
  3. Look for an asset that has set three consecutive lower lows and lower highs
  4. Look for a condition where the 50-day moving average crosses below the asset’s 200-day moving average

Using trendlines and moving averages to overcome the limitations of resistance levels

A resistance level is an easy concept to understand, particularly in range trading. An asset is said to be trading in a range when the price moves between key levels of support (on the low end) and resistance (on the upper end). This is displayed visually on a stock chart as a clearly defined channel that represents a static barrier for price movement. 

However, an asset’s price movement is generally more dynamic. This means that as the price of an asset trends upwards or downwards the resistance levels will change over time. Trendlines and moving averages are two additional technical indicators that can be used in tandem with resistance levels to help clarify price movement.

Using trendlines with resistance levels - An asset that is trending upwards will have a stair-stepping pattern of higher highs and higher lows. In this case, a trendline will be drawn underneath the ascending support levels. Conversely, an asset that is trending downwards will show a pattern of lower highs and lower lows. The trendline will be drawn above the descending resistance levels. A trendline will visualize the reality of price movement, meaning many assets that are ready to break out will test a resistance level several times before breaking out.

Using moving averages with resistance levels- A moving average is a continuous line that indicates where the average price of an asset has been over a fixed time frame such as 10-day, 50-day, or 200-day moving averages. A moving average is useful because it evens out outlying price data and can define support and resistance levels. Like a trendline, the moving average acts as a resistance level when an asset is on a downward trend.

The final word on resistance level

Supply and demand are one of the most important concepts for investors to understand. On a stock’s daily chart, traders can apply technical analysis to interpret supply and demand through the concept of support and resistance levels. When an asset, such as a stock, reaches a price level that it cannot bust through, it is said to have met a resistance level. A resistance level can occur as part of a clearly defined trading range or it can be more dynamic which is the case when an asset is in an uptrend or downtrend. Traders regard a resistance level to have higher significance when an asset’s price tests a resistance level multiple times, when it is preceded by a sharp price move in either direction, when there is significant trading volume at the resistance level, and when the resistance level has been in place for a long period of time. The correlating indicator to a resistance level is the support level which acts as a floor for price movement.

Trading strategies involving resistance levels either mean exiting a long position or entering a short position. While taking a short position against a resistance level seems like a very obvious trading strategy it involves a higher level of risk due to the fact that this trading is done with a margin account. Careful stops should be put in place to limit the upside risk if the resistance level breaks above the resistance level.

While resistance levels are frequently used in range trading, price movement can often be more dynamic. When an asset is moving in an uptrend or downtrend, other technical indicators such as trend lines and moving averages can help visualize the pattern of an asset’s price movement and help identify support and resistance lines.

 

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