Education: Momemtum Investing

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Support and Resistance: Simple Tools, Exceptional Results

Support and resistance are two of the most widely used technical indicators in trading and investing, largely due to their relevance and ease of use. These concepts are extremely important for the momentum investor because they can provide valuable signals about future price movement.

Support refers to a price, or price area, below current levels, where there is expected buying interest strong enough to reverse a decline. This level, or "floor," is relatively easy to spot when looking at a stock’s price history. It’s also worth noting that older support, that has turned back repeated price moves, is more important than new support, which has yet to be significantly tested. These levels become benchmarks, creating a self-fulfilling prophecy if you will, especially if formed over several years.

Resistance refers to a price, or price level, at which selling pressure resists, or pushes prices lower, overwhelming any buying interest. Resistance is at or above current prices and is often a prior high or a series of highs. The longer the resistance or "ceiling" has been established and the more it turns back repeated rallies, the greater its importance. After all, if this price area was an attractive point to sell in the past, maybe it will be going forward as well.

Investors can use support and resistance to initiate on either a reversal or a breakout. In both situations, the application of these concepts can provide powerful results. When going against the trend and playing a reversal, it is extremely important for investors to initiate as close to the key level as possible. When playing a breakout, it is important for the investor to wait for "confirmation" that the key level has in fact been breached, and prices are committed to establishing themselves in higher territory. And remember, support becomes resistance, resistance becomes support. These two concepts are almost interchangeable and equally valuable. Now that we have covered the basics, lets shift our attention to actual formation that have occurred in the market.

The first example is a six-month Nasdaq chart. This is an example of the concepts of support and resistance applied to a "breakout" situation. As you can see, as prices continued to test the key level at $44, they also continued to log higher lows, indicating that pressure was growing. When the breakout did finally occur, the results were profound. Within only two sessions, shares of Nasdaq tacked on an additional 10% in value, a great return by any standard. And interestingly enough, as previously discussed, this area of resistance then become support as shares dipped lower after profit taking.

The next example demonstrates the strength of these concepts when applied to a reversal situation. Prices of Brown Forman have established the area right around $67 as a base of support. Over the course of 12 months this area has been tested numerous times, and every time held up commendably, providing a very nice cushion and initiation point for investors.