and support levels. The argument for them assumes that
people usually remember when they've been burned, insulted,
or left out; in particular, they remember what they paid, or
wish they had paid, for a stock. Assume a stock has been selling
for $40 for a while and then drops to $32 before slowly
rising again. The large number of people who bought it
around $40 are upset and anxious to recoup their losses, so if
the stock moves back up to $40, they're likely to sell it,
thereby driving the price down again. The $40 price is termed
a resistance level and is considered an obstacle to further upward
movement of the stock price.
Likewise, investors who considered buying at $32 but did
not are envious of those who did buy at that price and reaped
the 25 percent returns. They are eager to get these gains, so if
the stock falls back to $32, they're likely to buy it, driving the
price up again. The $32 price is termed a support level and is
considered an obstacle to further downward movement.
Since stocks often seem to meander between their support
and resistance levels, one rule followed by technical analysts
is to buy the stock when it "bounces" off its support level and
sell it when it "bumps" up against its resistance level. The
rule can, of course, be applied to the market as a whole, inducing
investors to wait for the Dow or the S&P to definitively
turn up (or down) before buying (or selling).
Since chartists tend to view support levels as shaky, often
temporary, floors and resistance levels as slightly stronger, but
still temporary, ceilings, there is a more compelling rule involving
these notions. It instructs you to buy the stock if the
rising price breaks through the resistance level and to sell it if
the falling price breaks through the support level. In both
these cases breaking through indicates that the stock has
moved out of its customary channel and the rule counsels investors
to follow the new trend.
As with the moving-average rules, there are a few studies
that indicate that resistance-support rules sometimes lead to
moderate increases in returns. Against this there remains the
perhaps dispiriting efficient-market hypothesis, which maintains
that past prices, trends, and resistance and support levels
provide no evidence about future movements.
Innumerable variants of these rules exist and they can be
combined in ever more complicated ways. The resistance and
support levels can change and trend up or down in a channel
or with the moving average, for example, rather than remain
fixed. The rules can also be made to take account of variations
in a stock's volatility as well.
These variants depend on price patterns that often come
equipped with amusing names. The "head and shoulders"
pattern, for example, develops after an extended upward
trend. It is comprised of three peaks, the middle and highest
one being the head, and the smaller left and right ones (earlier
and later ones, that is) being the shoulders. After falling below
the right shoulder and breaking through the support line
connecting the lows on either side of the head, the stock price
has, technical chartists aver, reversed direction and a downward
trend has begun, so sell.
Similar metaphors describe the double-bottom trend reversal.
It develops after an extended downward trend and is
comprised of two successive troughs or bottoms with a small
peak between them. After bouncing off the second bottom,
the stock has, technical chartists again aver, reversed direction
and an upward trend has begun, so buy.
These are nice stories, and technical analysts tell them with
great earnestness and conviction. Even if everyone told the
same stories (and they don't), why should they be true? Presumably
the rationale is ultimately psychological or perhaps
sociological or systemic, but exactly what principles justify
these beliefs? Why not triple or quadruple bottoms? Or two
heads and shoulders? Or any of innumerable other equally
plausible, equally risible patterns? What combination of psychological,
financial, or other principles has sufficient specificity
to generate effective investment rules?
As with Elliott waves, scale is an issue. If we go to the level
of ticks, we can find small double bottoms and little heads
and tiny shoulders all over. We find them also in the movement
of broad market indices. And do these patterns mean
for the market as whole what they are purported to mean for
individual stocks? Is the "double-dip" recession discussed in
early 2002 simply a double bottom?
Read More : Resistance and Support and All That
