Resistance Line

An indication tool often used by investors or equity analysts to determine a company's stock price trajectory.

A resistance line is an indication tool often used by investors or equity analysts to determine a company's stock price trajectory. It is a crucial aspect of the technical analysis of assets.

resistance line

In particular, this line helps determine a stock's resistance and support levels. This is why they are crucial when deciding what positions to enter.

Resistance refers to a price level above which price does not tend to move over a specific duration of time.

It is named as such because the stock resists going above this level. It is a ceiling price or upper bound for that particular stock for a given period. 

It designates the resistance area in a downward trend, while in an upward trend, it designates the support area. We will discuss more support and resistance levels in the next section of this article.

Stocks can be volatile assets. Some stocks fluctuate more in value than others, making it difficult to choose when to enter or exit a trade wisely.

This line allows traders to make predictions of the movements of a company's share price. Hence, it is usually found in stock charts used by analysts.

It is also used for a variety of other assets, like, example, futures.

Support and Resistance Levels

If you have read a candlestick chart, you know that stock prices can be volatile. The more the price level changes, the more volatile the stock is.

support and resistance

The support and resistance levels act like invisible boundaries beyond which the stock price cannot, or rather, does not, move. The stock price fluctuates within these invisible boundaries.

However, the boundary can change over time as a company expands or shrinks operations, and its business prospects change in the long run.

The resistance level is a straight line joining one, two, or more of a particular asset's highest price point(s).

If a stock's price is rising and there haven't been any recent fluctuations, the resistance line would be at a slight incline. Conversely, if a stock's price is falling and there haven't been any significant swings, the line would decline slightly.

If the line appears to be horizontal, i.e., parallel to the x-axis, the stock is neither on an upward nor a downward trend.

While some traders prefer to use dynamic lines to determine support and resistance, others lean more toward horizontal lines.

Dynamic lines are named as such because they represent each slight fluctuation in the support and resistance over time. 

On the other hand, horizontal lines are said to be static since they only consider a single price level throughout, although this may change over time.

Drawing a Resistance Line

Each resistance line varies depending on the time interval being studied. This could vary anywhere from 5 minutes to several months. 

drawing a resistance line

An investor that wishes to examine short-term fluctuations would have a different line from one who wishes to investigate longer-term volatility.

The period you choose depends on whether you are a long-term investor, swing trader, or day trader.

Mentioned below are the steps you should follow when drawing a horizontal resistance line:

  1. First, identify a prior price level where the stock price has, over time, found it tough to break above or below. 
  2. Mark this price level with a horizontal line that extends into the future.
  3. It should resist pushing past this line when the stock price reaches this level.

Drawing a dynamic resistance line can be a bit more challenging. Most traders use moving averages automatically drawn on the candlestick chart by the charting software.

These moving averages are followed by many traders, reinforcing their relevance and efficiency.

Some widely used dynamic resistance levels are the 200-day exponential moving average (EMA), 100-day EMA, and 50-day EMA.

In this way, traders and investors can observe and follow the patterns present in stock movements to make profitable trades.

Functions

The primary function is to aid analysts in determining a stock's short-term trend, though it can also be used for longer time horizons.

functions

Determining the resistance and support levels allows us to identify target stock prices for buying and/or selling profitably.

Identifying resistance levels can also assist in risk management. For example, a trader can set a stop-loss/take-profit order, i.e., an order that tells the broker to buy or sell the stock when it reaches a given price level that follows the resistance levels.

If the stock price pushes past the resistance, the trade will be triggered, and the trader will make a profit/accept a loss.

According to technical analysis, available information about a company's stocks, bonds, etc., is already incorporated into the asset's market price. Hence, relying on this information to make profitable investments is futile.

Instead, traders can make profits by studying price patterns in the short term and observing price movements from the past during similar economic circumstances. For this reason, resistance lines are an essential tool for a technical analyst.

It makes it easier to observe price patterns, understand market psychology, and alter investment decisions accordingly.

The probability of the asset price reaching the resistance level and then declining is high. Therefore, it signals to the trader that the price has likely peaked, meaning it is an excellent time to sell the asset.

Looking at an Example

The following section presents an example of the concept to strengthen our understanding of the concept.

example

Let us consider the hypothetical example of Hecate Brewery, a publicly-traded beer company. Suppose Stephen studies the company's charts and wants to determine the best time to short it.

He observes that, over the past year, Hecate Brewery has traded between $12 and $20 per share. In January, the company was trading at $20 per share, but by April, the per-share price fell to $14. However, in July, the price rose to $20 again before falling to $12 the next month. 

Hecate Brewery's share price has trouble exceeding the $20 per share limit, implying that this is the brewery's resistance price.

If no news or announcement suggests that the stock could push past this price, it would be profitable for Stephen to sell the stock short at this point.

The market's history suggests that once the company's share price reaches $20, there is enough supply to prevent it from exceeding this level.

However, it is essential to note that fundamental factors, such as a strengthening economy or new efficiencies in a company's business strategy, can outweigh technical ones, breaking the resistance level.

Therefore, it is important to pay attention to these factors, even when analyzing a stock through technical means.

Potentials and Limitations

To understand the potential and limitations of resistance lines, let us look at another hypothetical example of LMN Sports, a publicly-traded sports equipment manufacturer.

skateboard

Based on the company's chart, its current market price is $150 per share, and its resistance is $155 per share.

We expect that if LMN Sports moves higher, it will face resistance. This implies that, as the company's price moves to $155, enough investors will begin to sell it and pull down its price.

However, who guarantees these sellers will come in and sell their shares when the company reaches $155? Neither you, nor me, nor an experienced trader can say with complete certainty that this will happen.

This implies that technical analysis hinges on history repeating itself. If price movements deviate from their previous patterns, traders could forego profits or even suffer losses. Therefore, these analyses should always be used with caution.

Yet, since it is observed that, historically, it would fall whenever LMN Sports reached $155, investors are likely to believe that hitting this price means it will fall soon. 

This encourages more investors to sell their shares at this point, maintaining the expectations of the resistance line.

In this way, $155 remains time-tested, and investors continue to believe that their expectations about the price point will be honored when it is reached.

This essentially creates a self-fulfilling prophecy where expectations lead to reality, leading to expectations being reinforced, and so on.

Key Takeaways

  • A resistance line is an indication tool frequently used by investors or equity analysts to forecast the price movement of a company's shares.
  • It is part of the technical analysis of securities. Technical analysis uses charts to predict future price fluctuations and identify a trade's profitable entry and exit points.
  • To draw it, we must first identify a price point the stock has been unable to exceed in the past. Draw a horizontal line from this point and extend it into the future.
  • It is likely that, in the future, when the stock nears this price point, it will find it difficult to break through. This makes for an excellent shorting strategy.
  • Horizontal lines are not the only way of drawing it. Another prominent form of removing these lines is to draw them dynamically to reflect each little movement in the stock prices.
  • Although it may also be utilized for longer time horizons, the resistance line's primary purpose is to assist analysts in assessing a stock's short-term trend.
  • One should not expect the resistance line to always hold with certainty. Situations may arise where the asset price goes beyond the line, resulting in foregone profits or even losses.
  • It is essential to consider fundamental aspects such as economic growth, change in company management, etc., that may alter a company's prospects, thereby impacting its share price.
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Researched and authored by Rhea Bhatnagar | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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