This is a technical analysis question that is difficult to explain without several examples. I will, however, attempt to explain the basics. We will be conducting seminars later in the year, and one will be devoted primarily to technical analysis.
Resistance and support levels are exactly what their names imply. Resistance is a price level a stock or average finds it difficult to break through. Support is a price level a stock or average tends to hold above. We use these as trading signals as stocks often bounce up off of support levels or break through resistance levels if they are going to move up. Similarly, stocks will fall through support or bounce down off of resistance if they are going to fall.
What creates support and resistance levels? Support levels are created many ways. One of the easiest to watch is moving averages. When a stock is moving up in a rally as we saw in November and December, the 10 and 18 day moving averages often act as support and will propel a stock back up as it pulls back to that level. When the selling gets more intense, a strong stock will use its 50 day moving average as support. If a stock has been using a particular moving average as support and the stock falls through it, that is a break of its pattern, and is a caution flag. When a stock breaks its 50 day moving average on strong volume, that is another caution flag as the 50 day moving average is a critical level for stocks that are trying to keep moving up.
Trendlines are similar to moving averages. They are formed by the line connecting the lows of a stock moving up (an up trendline) or the highs of a stock moving down (a down trendline). The more times a stock hits a particular trendline, the more faith we have that the line will act as support.
Support is also formed the longer a stock stays at a particular level. Whenever a stock hits a particular level, imagine that it puts a groove in that level. Every time it touches that same level, it makes a little bit deeper groove. Picture a stock moving sideways day after day. It moves up off of that level with some pretty big moves, but then the market sells. As the stock slides back down the backside of the hill it built on the move up, it skims over the levels it never closed at. When it hits one of those ‘grooved’ areas where the stock spent a lot of time, it tends to fall into that ‘grooved’ area and that stops the slide. Old tops in such a grooved area are usually the strongest support, but the lows in the grooved range can also hold. If the selling is intense, it may push the stock right past the grooved area-the longer a stock stays at a level, the stronger the support.
When a stock forms a base, e.g., cup with handle, flat base, wedge, etc., the breakout point becomes support. The reason is that the stock hit the breakout point when it started to correct and spent the time since hitting that high consolidating and weeding out the weak holders. In getting back up to the high to attempt the breakout, the stock has had to get ride of all of those holders that bought at the high and as the stock started to correct. Many will sell as the stock consolidated, and many more as the stock approaches the old high. Often stocks will ‘shakeout’ the last weak holders just as it approaches the old high (breakout point) by moving down on lower volume. The holders who thought they might get out even say ‘to heck with it,’ and sell. At that point, all of the investors that bought at the old high are most likely gone and the majority of the holders bought at better prices and are anticipating a move up-they hang onto their shares. When the stock breaks above the old high, buyers flock into the stock. The stock has built a ‘base’ of support after all the sellers were weeded out. The new holders bought when the stock was at a lower level or when it broke out. They are inclined to keep their shares as long as the stock holds above that breakout level. That gives the stock support at that level. Institutions are big buyers on breakouts, and they will often step in and buy stocks at support levels to keep the stock moving as well.
As for resistance, you basically take the flipside of support. Lines that act as support become resistance when they are broken. Resistance lines become support when resistance is broken. Old highs can act as resistance. That is what makes a breakout of a solid base such a good upside play-resistance is broken and the stock can move up as there are no owners out there holding the stock at a higher price who could undermine the move by selling.
Take a look at the attached chart of BRCM. Note how the old tops act as support each time the stock started to sell back in November and December. That also coincided with the 18 day moving average. When BRCM broke below its 18 day moving average last week, it still held at the old top set in early December. (Click to view the chart)