What is a Support and Resistance?
Think of prices for financial instruments as a result of a head-to-head battle between a bull (the buyer) and a bear (the seller). Bulls push prices higher, and bears lower them. The direction prices actually move shows who is winning the battle.
Support is a level at which bulls (i.e., buyers) take control over the prices and prevent them from falling lower.
Resistance, on the other hand, is the point at which sellers (bears) take control of prices and prevent them from rising higher. The price at which a trade takes place is the price at which a bull and bear agree to do business. It represents the consensus of their expectations.
Support levels indicate the price where the most of investors believe that prices will move higher. Resistance levels indicate the price at which the most of investors feel prices will move lower.
But investor expectations change with the time, and this can happen abruptly. The development of support and resistance levels is probably the most noticeable and reoccurring event on price charts. The breaking through support/resistance levels can be triggered by fundamental changes that are above or below investor's expectations (such as changes in earnings, management, competition, etc.) or by self-fulfilling prophecy (investors buy as they see prices rise). The cause is not so significant as the effect: new expectations lead to new price levels.
Supply and demand
Support and resistance lines deal with classic supply and demand. Supply/demand lines show what the supply and demand will be at a given price.
The supply line shows the quantity (i.e., the number of shares) that sellers are willing to supply at a given price. When prices increase, the quantity of sellers also increases as more investors are willing to sell at these higher prices. The demand line shows the number of shares that buyers are willing to buy at a given price. When prices increase, the quantity of buyers decreases as fewer investors are willing to buy at higher prices.
At any given price, a supply/demand chart shows how many buyers and sellers there are. In a free market, these lines are continually changing. Investor's expectations change, and so do the prices buyers and sellers feel are acceptable. A breakout above a resistance level is evidence of an upward shift in the demand line as more buyers become willing to buy at higher prices. Similarly, the failure of a support level shows that the supply line has shifted downward.
The foundation of most technical analysis tools is rooted in the concept of supply and demand. Charts of prices for financial instruments give us a superb view of these forces in action.
Resistance becomes support
When a resistance level is successfully broken through, that level becomes a support level. Similarly, when a support level is successfully broken through, that level becomes a resistance level.
The reason for it is that a new "group" of bulls appears who refused to buy when prices were low. Now they are eager to buy at any time the prices return to the previous level. Similarly, when prices drop below a support level, that level often becomes a resistance level that prices have a difficult time breaking through. When prices approach the previous support level, investors seek to limit their losses by selling.