I was recently asked a question on Quora (“What does support level mean in a technical chart of a stock?“), and after I finished answering it, I realized it was way too long not to share here. So here it what I said:
Although I’m a chartist, I will answer this in “human” rather than chart-based terms. I’ll use a rather facetious example to make my point.
Let’s say a given stock X traded between $50 and $51 for two solid years. Countless people bought at that price. It was boring but very, very stable.
Now let’s say for whatever reason the stock vaulted swiftly over the course of a month up to $80 per share. Perhaps there were takeover rumors or optimism about a new product line. So now you’ve got a huge mass of people with nice fat profits, as well as some newcomers who paid between $51 and $80 for the same stock.
So now you have two classes of owners – – a large mass of folks with a good basis price and big profits, as well as newcomers whose profits range from decent to very small, depending on the price they paid. This latter group is going to be quite nervous and have weak hands. The former group will be more confident, since they have a much lower basis and have grown accustomed to the stock never being below $50.
All right, so news comes out that starts to depress the stock. Maybe the takeover isn’t happening. Or maybe the new product line isn’t selling well. So the security starts declining in value.
The newcomers are going to bail in a big hurry. From a psychological perspective, they don’t want a loss. It hurts too much. And they are not acquainted with this stock they just bought, or its nature, so they want to get the hell out. So they dump it and leer every time they see its ticker symbol. It has harmed them.
The huge mass of owners between $50 and $51 are watching the stock descend from 80 to 75 to 70 and so on. They aren’t thrilled with this, but they aren’t panicking either. Their obscene profits are simply shrinking somewhat. This mass of people represents a psychological “wall” against selling pressure.
The reason is that as the price reaches the lower 50s (should it fall so far), there are two things this mass is going to be inclined to do (a) acquire more stock since it seems “cheap” compared to where it was recently, and since their relationship with the stock has been an altogether positive one, even with the reduction in recent profitability (b) at a minimum hang on tight to the stock they have. In other words, the number of people willing to sell the stock is going to dry up. Picture a wall of people with their arms crossed, indignant at the notion of dumping their stock for anything less than they paid.
This wall of people is “support’. On a chart, it looks like a lot of price bars clustered at a certain level. But there are real humans with real emotions behind every one of those bars.
Now let’s take this example even farther and say more bad news comes out. Perhaps a video is circulating on the Internet showing that the CEO spends his weekends dressed in a pink fairy outfit and runs around playgrounds in his hometown singing saucy sea shanties in a high-pitched voice. The sanity of the company’s leadership is questioned, and now the shares start moving down to 49, 48,47………….
At this point, those arms are going to start uncrossing. One by one, people are going to decide that a small loss is better than a big one, and they’re going to dump the stock. They’re going to resent the fact that a big profit has now turned into a loss, and they’ve been “betrayed” by their once faithful security position. The selling builds, and more people decide to get out.
This is the magical point where what had been “support” is now “resistance”. The simple horizontal line on that chart has changed roles. Whereas before it had acted as a floor to slow down a price drop, now it is a ceiling.
The reason it is a ceiling is likewise easy to understand in human terms. That mass of people whose arms were formerly crossed now drops to their knees every night and prays to the market gods: “If you can just get me out of this position without a loss, I’ll never touch it again. Honest. I promise. Thank you.”
It turns out the video circulating was just a humorous video the CEO made for his kid’s birthday party. There was a totally innocent explanation, and the public actually thinks he’s a pretty cool dad for making a fun video, which shows he can laugh at himself even while being a responsible corporate leader. So people start buying the stock again. 47……48……..49………50…….
Then, BANG, the selling starts again. Why is that? You already know the answer. Because the prayers of many people have been answered, and they can dump this turkey with no loss and stop thinking about pink fairies and prancing CEOs. They are grateful to have been patient enough to see a loss turn into a scratch, and they get the hell out, never wanting to see that ticker symbol again.
And that, my friends, is the tale of support and resistance.