There are also proactive methods to determine what the future SL & RL is going to be. If the long-term forecast for a stock is favorable, it tends to crack past the RL eventually and climb up to the next 1. This next RL or SL can be predicted using methods like trendlines and calculated pivots.
The reasoning behind these support and resistance levels and also the procedure of identifying them is really a complex and ongoing problem because they can change over time. Let’s shed some light on this with the help of investor psychology, and then outline the technical aspects. Consider an investor who has just bought a share for $100.
It is interesting to watch a stock drop to a certain price level a number of times, then bounce back up in price. The stock is said to have bounced off a support level. It is equally interesting to watch a stock rise to a certain price level, and each time, it is like hitting a ceiling. The stock drops back down in price. This is caused by human nature, or common human reactions. They show up on the stock charts as support and resistance levels. This is an important aspect of stock market technical analysis.
This type of self-fulfilling herd mentality by investors ensures that every time the stock nears $120, there will be rush to the exits and the stock will drop. This is referred to as a resistance level. The same principle applies for stocks on their method to the bottom. Once a stock bounces back up at a certain cost (like $110 within the above example), it becomes a support level in future where investors searching for value step in and also the stock starts rising.
As an example, if a stock trades for 2 months between $24 and $28 per share, the support level becomes $24. The resistance level is at $28 per share. If the stock breaks out of this trading range, and goes up to something like $28.75, we now have what is called a “breakout”. The savvy trader will analyze the volume on the day of the breakout. If the volume is much larger than normal, the breakout would be considered valid, and have a much greater chance of success. This is a stock market technical analysis key. It also adds validity to a breakout if the stock closes above the resistance area it earlier broke through.
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