Support and resistance

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One of the hardest aspects of investing is to discipline oneself not to fall prey to normal human emotions when buying and selling shares. Pride and hope have no place in investment decisions. Investing must be dispassionate. Fear and greed need to be kept under control.

These are hard skills to acquire and keep. This is proved by the fact that emotions like this very obviously do play a role in the market. And quirks of human behaviour can be observed in the way chart prices move.

For more on the impact of emotions on trading, read: Taming your emotions.

One of the obvious ways in which this manifests itself is in the concept of support and resistance levels. These are the points on charts where prices churn around and shares seem reluctant to fall below - or rise above - a particular numerical value on the chart. What is coming into play here is the reluctance of individual investors and traders to miss out again on a profit by failing to sell at a particular high point the shares have previously reached, or a disinclination to pay more than a specific price for a share if they once bought it cheaply at a particular level.

Let's say that, for example, you bought 1,000 shares in Vodafone (VOD) at 100p. Things go well and over the next few months the shares rise to 140p.

Having made 40% on your money you might consider selling, but let's say that before you can do so, the market price starts falling back towards 100p, coming to rest at around 120p. You might think it's too late to sell and just hang on to the shares in case they rise again.

Let's then say that the shares do rise back up towards their earlier high. As they approach 140p for the second time you are in a quandary. When they reached this price before, market selling came in which depressed the price. Might the same thing happen again? If so, it might be better to sell before it does.

This intention to sell and the many similar ones made by other like-minded investors make for a high probability that the shares will bounce back down from the 140p mark all the more likely.

The other side

It works on the 'buy' side too, but in a different way.

Imagine that another investor bought the shares at 140p a year or so back and had seen them fall back to as low as 100p in the meantime. Rather than crystallise a loss, he held on hoping the shares would recover. But as they approach his initial buying price, the point where he can get out of the shares at no loss, the temptation to sell is strong. These two types of investing predictament reinforce each other and create an area of resistance that is visible on the share price chart.

So-called support levels work from a different set of circumstances. Imagine now that you bought your Vodafone shares at 100p and successfully sold them at 140p.

If the shares were to drift back down to the 100p level you might take the view that there was the opportunutity to repeat a previous successful trade and buy at 100p. That's particularly the case if this is a cyclical pattern that has been repeated more than once.

The very fact that several investors think this way and buy at around this price means that the shares will 'bounce' up once they hit 100p, perhaps triggering more buying interest from people who missed hitching a ride last time round. By the same token, they may later bounce down from the 140p level for the reasons described earlier.

This mixture of the herd instinct and conditioned reflex can be very apparent on share price charts and buying and selling actions can be timed accordingly in an attempt to profit from them.

Peter says

The objective of technical analysis is to assist in spotting the points at which profitable trades can be made. Those decisions need not, despite what chartists may say, be made irrespective of the fundamentals. Chart analysis, including the use of support and resistance levels, can be used to time more precisely the purchase of a share that you have, for instance, already decided looks attractive on fundamental grounds.

But using support and resistance does not work in all cases. Underlying fundamentals can change quickly and, if they alter in a major way, all bets are off. Trends and cyclical patterns are not necessarily reliable, and certainly do not hold good forever. When they do change, it is no good expecting the old patterns to re-emerge. A fundamental reassessment has to be made with the old assumptions cast aside and a new strategy formulated.

Just as fear, greed, pride and hope have to be guarded against when investing, so too does the temptation to stick for too long to outmoded assumptions about share price behaviour. While there is comfort in using familiar patterns, the lesson really is that it does not pay to be too dogmatic or to believe that the market can be outwitted for any length of time.