About Support and Resistance levels in stock chart patterns

One of the reasons why technical analysis seems to work (at least some of the time) is that support and resistance levels frequently appear and re-appear in stock chart patterns.

I have already discussed Fibonacci retracement levels in several posts. Time and again, a 38.2%, or 50%, or 61.8% retracement of a previous up or down move show up on chart patterns and help in determining entry and exit points.

Understanding support and resistance levels will provide important indications to determine when a rally or a correction may come to an end. During an up trend, when a previous top is conquered, it becomes a support level. In a down trend, if a previous bottom is broken, it becomes a resistance level.

Why and how does it work? It could be because of 'recency bias'. Investors tend to remember what price level a stock price recently rose (or fell) to, and how they had missed benefitting from those price levels.

It may also be because a lot of technical traders are playing in the stock market, and it is their business to know previous support and resistance levels. They sell when a resistance level is hit, and buy when a stock finds support.

Let us look at the two years closing chart pattern of Reliance, where a number of support and resistance lines have been drawn:-

A minor top of 2400 in Sep '07 was soon conquered and became a support level in Oct '07 (line 1). The top of 2650 made in Oct '07 was quickly followed by a correction that halted at 2410 - close to the previous top of 2400.

The 2650 top was passed later in the month and became a support level through Nov and Dec '07, till it was breached in Jan '08. It immediately turned into a resistance level, that withstood three tests during Apr and May '08 (line 2).

The Jan '08 low of 2360 was broken briefly in Feb '08 and then again in Mar '08 and became a resistance level for a month. But note how it turned into a much stronger resistance level that thwarted all subsequent up moves - in Jun. Jul and Aug '08, and then again in May and Jun '09 (line 3).

The Mar '08 low of 2145 has similarly acted as a long term support and resistance level till date (line 4). The 1500 level also acted as a support and resistance level during the sideways consolidation from Oct '08 to Mar '09 (line 5).

A couple of important points to remember:-

1. The 3% 'whipsaw' lee way should always be applied. That means any breach of a support or resistance level will be valid only if the price clears the previous level by more than 3%.

2. Support and resistance levels act as thin rubber membranes if the level is tested two or three times in quick succession. The level gets weakened and usually won't be able to withstand a fourth test.