Support and resistance, what they are and are not

In short

I once watched a man at a coffee counter tape a printed stock chart to the wall and draw a line across it with a red pen. He said the price would never go past that line. You have probably met a chart like that, or drawn one yourself. Support and resistance are price levels where a stock has stopped or turned around before, and traders watch them for that reason. They are a record of the past, not a promise about the next hour. Treat any level as a place to pay attention, not a place to be certain. Write down, before you ever place a trade, how much you are willing to lose if the level fails. Keep your position small enough that being wrong is a bruise and not a broken bone.

The whole of it

What it is

A friend of mine spent years working the floor of a hardware store, and he liked to say that people remember the prices they once paid. He was onto something. A stock chart is a picture of prices over time, and some prices show up again and again as turning points. When a price has fallen to a certain level and then bounced back up, that level is called support. Think of it as a floor the price has landed on before. When a price has climbed to a certain level and then dropped back, that level is called resistance. Think of it as a ceiling the price has bumped against before.

You will hear traders explain these levels with a story about people. Buyers who got in at a low price may step in again when it returns there. Sellers who got stuck at a high price may sell the moment they get even. That story is a reasonable way to think about it. But it is a story, and nobody can prove it will play out again.

Here is the part worth holding onto. Support and resistance are drawn by people looking at a chart. Two careful people can look at the same chart and draw slightly different lines. That does not make either of them foolish. It just means the lines are a matter of judgment, not a measurement handed down from the exchange.

How it works

If you are holding a chart in front of you right now, look for the spots where the price turned around more than once. Those are the candidates. A level gets more attention when the price has touched it several times and held. Traders also watch round numbers, such as 50 dollars or 100 dollars, because people like round numbers and tend to place orders there.

When a price finally breaks through a level, the old ceiling can turn into a new floor, and the old floor can turn into a new ceiling. Traders call this a role reversal. A break is not always real, though. Sometimes the price pokes through for a moment and then snaps back. Traders call that a false breakout, and it catches plenty of careful people.

Notice the word "watch." A level is something you watch, not something you obey. It tells you where to look for trouble or opportunity, and it gives you a spot to decide in advance what you will do. That last part is the real value. A level lets you say, before the money is at risk, "If the price falls below here, I was wrong, and I will step out."

The numbers, and where to find yours

Support and resistance have no official number. No law sets them. No agency publishes them. Your levels come from the price history of the specific stock or fund you are studying, and you find them by looking at its chart on your brokerage platform or a charting site.

What the law and the exchanges do set are the costs and rules around trading. If you trade in a regular taxable account, the tax on your gains depends on how long you held the position. The IRS explains this in its publication on investment income and expenses, Publication 550, and in Topic 409 on capital gains and losses. Gains on positions held a year or less are taxed as short term gains, and the rate structure is set each year. The current rates and thresholds are the current figure, which the official source publishes each year. Losses can offset gains, and the wash sale rule can disallow a loss if you buy back the same security too soon. Both are covered on the IRS pages just named.

Trading also has a rule about account size. FINRA, the industry regulator, sets a pattern day trader rule for people who trade the same security in and out within a single day many times. The minimum account balance for that rule is the current figure, which the official source publishes each year. FINRA explains it on its own site. Read it before you trade often, because it can limit what you are allowed to do.

A worked example

Let me tell you about a woman named Denise. She works as a dental hygienist and started watching a stock she liked. She saw that over six months it had dropped to about 40 dollars three times and bounced each time. She called 40 dollars her support. It had also climbed to about 48 dollars twice and turned back. She called 48 dollars her resistance.

Denise did not want to guess. She wanted a plan she could check. So she wrote down her numbers before doing anything. She decided she would only consider a purchase near 41 dollars, just above her support. She decided that if the price closed below 39 dollars, she would consider the level broken and step out. That left a gap between her entry and her exit.

Now watch her arithmetic. She would buy at 41 dollars and exit at 39 dollars if wrong. The gap is 41 minus 39, which is 2 dollars a share. Denise had 10,000 dollars in her trading account. She told herself she would risk no more than 1 percent of it on one idea. One percent of 10,000 is 100 dollars. So the most she could lose on this idea was 100 dollars.

With a 2 dollar risk per share and a 100 dollar limit, she divided 100 by 2. That gave her 50 shares. At 41 dollars a share, 50 shares cost 2,050 dollars. That is about 20 percent of her account, but her real risk was only the 100 dollars she had chosen. Notice what she did there. She let the level tell her where to exit, and she let her own comfort tell her how big to go.

She also looked at her possible reward. Her resistance was at 48 dollars. From 41 dollars, that is a gain of 7 dollars a share, and 7 times 50 shares is 350 dollars before costs and taxes. She was risking 100 dollars to possibly make 350 dollars. That is a ratio worth thinking about, but it is not a forecast. The price might never reach 48 dollars. It might fall through 39 dollars in a single night and open lower, so her loss could be bigger than 100 dollars. She knew that too. This example teaches how she reasoned, not what anyone should buy.

Where it goes wrong

I have made this mistake myself, so I say it kindly. The most common trouble is believing a level is a wall. It is not. It is a spot where people happened to act before. Prices slice through support and resistance all the time, and news, earnings reports, and shifts in the wider market can push a stock through any line you drew.

Another trap is drawing lines after the fact. Look at any old chart and the levels seem obvious. That is because you already know what happened. In real time, the chart is messy, and you will draw a dozen lines that mean nothing. Be gentle with yourself about that. It happens to everyone.

A third problem is thin trading. A level on a stock that few people trade is less meaningful, because a handful of orders can move it. And the last trap is the one that hurts the most. People skip the exit plan. They buy near support, the level breaks, and they hold on, hoping it will come back. Hope is not a plan. Decide your exit first.

Questions to answer before you leave this page

If you were to trade near a level, where exactly would you step out if you were wrong, and could you write that number down right now? How much money can you lose on one idea without losing sleep, and have you turned that into a share count you can show your work on? Do you know the difference between a level that has held three times and one you simply hope will hold? Have you read the IRS pages and the FINRA rule named above so the costs and limits of trading do not surprise you? And are you looking at this level because the chart shows it, or because you already wanted the trade?