Last week, I defined the various downturn terms (pullback, correction and bear market) to ensure that everyone was talking from the same definitions. Well, we just got an up close look at a market correction. It was swift and brutal, but only lasted for a couple of days. While the downturn was playing out, you had wise people expounding on TV that the correction would hit support levels, where the bleeding would stop. In fact, the market “broke through” several support levels on its way down until it finally hit its ultimate support level that held up.
Support and Resistance Levels, Defined
So, what exactly are support and resistance levels? Support levels are levels for the market in general or individual stocks where there is a natural barrier that “supports” a stock from crossing. For example, a stock that is trading between 100 and 105 may find support at 95. While this sounds like people are pulling these numbers out of the air, there usually are good reasons why these levels are out there.
When a stock is dropping, assuming no substantive new information has come out, there are mechanisms that will kick in to slow the descent. Algo trading which deploy massive amounts of cash can unleash a flurry of buy orders. The algo might have been triggered by the price decline, and believes that the stock is now poised to correct. Additionally, people might have limit orders that trigger when a stock hits a certain level. Finally, market watchers may conclude that there is now enough value in a stock that it is time to buy.
The price levels where support exists is often one of these levels:
- A prior 50-day low
- The 200-day moving average
- A dollar level that the stock hit last time it was under pressure
Usually, a quick view of the chart will highlight the natural support and resistance levels. You will see the stock’s price bounce of these levels.
On the other side, there are natural resistance levels that will naturally impede stock price increases. When the stock price (or market price) breaks through these levels, they often have further room to go. Again, in both support and resistance levels, the same factors are in play in terms of algos, and in this case people or institutions taking profits on stocks that they own.