Support becomes resistance (and vice versa)

Often, when a support or resistance level has finally been broken after multiple attempts, the price action will turn and re-test it from the opposite direction. This can make stock traders, who have entered the market once the breakout has been confirmed, pause and worry if they made the correct decision.

A support or resistance level forms as commercial and institutional traders defend a position by adding to an existing one:
•    If the trader holds a long position and the price action is approaching a support level, he’ll purchase additional shares to prevent the price from falling beneath that level. By driving the price and volume higher, he’s hoping to initiate a rally and convince other traders to help hold the line.

•    If the trader holds a short position and the price is nearing resistance, he’ll sell additional shares to stop the rally, drive the price and volume lower, and garner assistance from other traders.

If no other traders join the fight, however, the trader’s defence will be overwhelmed and the price action will roll through the support or resistance level. The trader is left holding a large, open position that’s rapidly losing money.

But perhaps the rally or decline didn’t have sufficient volume or momentum to continue rising or falling. Perhaps, underneath it all, the breakout was false, and the price action returns to the support or resistance level. Once it’s there, the trader is likely to exit the position:

•    If he was long in the market and the price spiked through its support level, he’ll sell his shares, transforming his steady buying pressure into sudden selling pressure.

•    If he was short and the price spiked through resistance, he’ll purchase shares to cover, transforming steady selling pressure into sudden buying pressure.

And so, instead of falling back beneath the resistance level or rising back above support, the price action’s new move gains momentum and volume both. The breakout is confirmed by the move, the technical level withstands the test from the opposite direction, and the new trend is on.

When last analysed, InvoCare Limited (IVC) was being squeezed between a bullish trendline and a strong resistance level at 6.50. The trendline won and the price action popped above resistance on 1 September, rising to a new 52-week high of 6.85 the next day and then turning to re-test the resistance level as support, as shown on the chart, below:

Because the resistance line coincides with the 50% retracement level, thus doubling its strength, it’s likely to withstand the re-test from the opposite direction, as support. Back in the fourth quarter of 2007, IVC reached highs near 7.50. Those highs seem likely to face testing themselves should the rally continue.

technical analysis by Craig Liles