Support, Resistance and Channels
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One of the most important principles involved in understanding technical analysis, and subsequently profitable trading, is support, resistance and channels.
Support and Resistance can be defined as follows:
Support is a price level to which prices tend to descend but not pass through.
Resistance is a price level to which prices tend to ascend but not pass through.
Support is simply the point at which selling exhausts itself and buyers come back into the market. Resistance is the opposite. At this point buying exhausts itself and selling begins.
One very important point about support and resistance is that when a major resistance level is penetrated it usually becomes new support, and when a major support level is broken it usually becomes new resistance.
It can also be said that the longer a support and/or resistance level is in place the heavier the breakout once prices break through these levels. In the above chart of American Commercial Lines (ACLI) you can see that resistance was around $56 for a longer time. Once prices broke out above resistance the stock went right up to $75.
But what can also happen once a support or resistance level has been broken is that prices fall back above or below these lines like you can see in the chart of Amazon (AMZN) below. Twice prices broke out above resistance and dropped back again i.e. twice resistance became support and prices broke through support again.
Amazons chart brings us to the next point. Support and resistance levels just like channels don't have to be level like depicted on the first chart of ACLI. They can also be sloped upward or downward. They can have one line or two lines.
The two following charts, Merrill Lynch (MER) and Johnson & Johnson (JNJ) explain this very clearly:
If you find a chart where you can draw lines of support and resistance as pronounced as with ACLI or JNJ, then you've got what is called a channel.
A channel is where stock prices reside within support and resistance. Just like with support and resistance, all you have to do to construct a channel is draw a trend line along the highest prices over a period of time, and then draw a second line along the lowest prices over the same time period. These two trend lines will then form the channel.
Notice how the stock price seems to hit it's head on an invisible ceiling. The price then falls down only
to bounce off an imaginary floor until it hits the ceiling again.
And just like with support and resistance, the longer a channel is in place the heavier the breakout will usually be.
When a stock breaks out of a well established channel, with increased volume or other confirmation, it is a good signal for a possible trade.
Ricky Schmidt
January 12, 2007
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