There are a couple of key points that relate to price movement that need to be discussed, support and resistance levels.
Support levels refer to price levels that support the price and usually point to higher prices in the future; this is an area of demand. Resistance levels refer to price levels where the price cannot rise any further, where there is a supply of stock. The technician just observes that the levels are there.
The figure below shows a stock in a downtrend. The stock bounces to A then proceeds to move down to B where the demand for the stock comes in. Remember the market is made up of a number of players, some buyers who bought at B take profits at C. Another group of investors who bought at A and watched it retreat to B are happy to get out at C. This composite viewpoint results in a resistance level at C and causes the price to move down from C. When the price retreats again to D the buyers who bought at B and sold at C are buyers again. This type of action is called support, where buyers are prepared to take positions once again. This demand pushes prices back up to E where the selling begins again reinforcing this resistance level for the stock.
This causes the price to fall once more to F where the same short term buyers once again emerge. Point G is as far as the price will move since the short term traders have determined that it will not go any higher. The price moves once again to the support level at H where the stock is absorbed once again. Then the stock moves to I and then back to J giving another opportunity for participants to get involved. But, this time the sellers are in control and the price drops below J.
Buyers had been confident at purchasing at the support level so much so that they increased there buying at that price point, and for the first time they are in a losing position. Some of those same buyers will sell their positions immediately creating a selling wave, others will just hope and pray that the stock price will recover. At price point K the stock has become oversold and short term buyers come in again looking for a profit. The stock rises back to L with the new buyers selling and the previous buyers at B, D, F, H and J sell to break even.
The move to L does not last for long and the selling begins once again. So, the point L level which had been support has now become a point of resistance. The price falls to M. At M the point is reached where demand overcomes supply and pushes the prices upwards.
Now there are a number of holders of the stock that bought at B, D, F, H and J levels who are still holding there positions. They’re thinking that if the price could just get back to where they had purchased the stock they would get out for good. This creates even more resistance at the L level which remember had been a point of support. When the price rises back to N they start selling which forces the stock price back to O. L and N will continue to be strong resistance points until there are no sellers at that level.
Your wondering if this really happens? Take a look at the chart below……
The support level is around 24 with the resistance level at around 26. The stock temporarily moves below support much like the example above, investors bailed before the demand once again came back in. This demand pushed the stock back into its previous trading range between 24 and 26.
The classic buying opportunity developed as the stock rose above its resistance level and then tested that level making it now the support level. From that point the supply of stock was reduced and the stock price began to rise.