Ultimate Guide to Technical Resistance Levels

Resistance is a technical analysis concept used by stock traders to find potential entry and exit points, as well as provide analytical insight for current trades. Traders do this by learning what resistance is, how it is established and knowing what your options are when the price reaches resistance. This knowledge is then implemented into a strategy, likely along with some other technical analysis concepts, so that when the time comes the information can be used to make trading decisions.

What is Resistance?

Resistance is a price level or area where the stock stopped advancing and pulled back. Think of it like a ceiling, where buyers met resistance from the sellers, forcing the stock lower. Resistance can occur at the exact same price multiple times (not very often), or the price meets resistance at slightly different prices, forming a “resistance zone/area.” For example if the price stops advancing and retreats between $10 and $10.20 on multiple rallies, there isn’t just one price providing resistance, rather the whole $0.20 area is resistance.

The resistance zone is marked by drawing horizontal lines on the chart for future reference.

Once we have drawn these lines, the price may “hold/respect” the resistance zone, and the price will fall away from the area. In other words, the price fails to breakout above resistance. Figure 1 shows a resistance area based the high points of several price swings in the same general area. Once the first high is in place, it is potential resistance, and any later rallies into that area, which also fail to advance higher, confirm the resistance area.

Figure 1. Resistance Holds - XL Group (NYSE:XL) Daily Chart

The price could also “break resistance” by advancing through the resistance zone. This is shown in Figure 2.

Figure 2. Resistance Break - HD Supply Holdings (NYSE:HDS) Daily Chart

Using Resistance Levels to Trade

Since resistance will either hold or be broken, there are two approaches to trading off of resistance.

1. Sell or take short positions near resistance, once the price has reached the resistance zone and then begins to drop away from it. This indicates that the resistance zone has held and the price could continue to decline. If a short position is taken, a stop loss is placed above the resistance zone.

If you already own the stock, and the stock fails to break above resistance, you want to consider selling it. This is because if resistance held, the price could be in for a decline, at least over the short-term.

Figure 3. Selling or Shorting When Resistance Holds - Embraer Aircraft (NYSE:ERJ) Daily Chart

2. Price may also break resistance, in which case, it gives a signal to buy (or continue to hold long positions). The indication is that this is a breakout, and therefore the price will advance higher. Buying on a breakout can be lucrative, but also risky, since false breakouts are common.

A false breakout is when the price moves beyond a resistance zone, appearing to be a breakout, but then quickly retreats back below the resistance zone, causing a trading loss.
One way to avoid trading some false breakouts is to let the price breakout, then buy when the price moves back toward the resistance zone, and then begins to advance again. This is called a “second chance entry.” Stops are placed just below a recent swing low (in price) or just below the old resistance zone.

If in a short position and the price breaks above resistance, many traders will exit that short position, since the breakout indicates the price could continue to rally (assuming it isn’t a false breakout).

Figure 4. Buying on Resistance Break - Allstate (NYSE:ALL)

Traders often add a small buffer to the top of the current resistance zone. Only buy a breakout if the price moves above the zone and your buffer. This gives the price a bit of extra room, helping to differentiate between false breakouts and legitimate breakouts. The size of the buffer will generally be bigger for higher priced and volatile stocks, and smaller for low volatility and low priced stocks.

Considerations When Using Resistance

Resistance may look easy to trade in hindsight, but in real-time it isn’t so easy. We can’t know in advance whether a resistance level will hold or break, for if there will be a false breakout. This is why many traders wait to see what the price does at a resistance level—bounce off of it, or break through—before taking a trade.

False breakouts are common, but many traders love to buy resistance breakouts. If the breakout turns out to be false, the trader is entering right near a high where the price is likely to retreat from. Adding a small buffer to the top of resistance zone, may help reduce the chances of buying a false breakout. The downside is that by waiting for the price to move above the buffer as well, a higher price will be paid for the stock.

The Bottom Line

Resistance is like a ceiling, where sellers step in and keep a stock from going higher. Use resistance to find trading opportunities, such as buying resistance breakouts, second chance entries, or selling/shorting if resistance holds. In advance we don’t know whether resistance will hold or break, therefore measures such as adding a small buffer to the zone, or waiting for the price to react off the resistance zone may help reduce getting caught in a false breakout.

Did you know that...

Setting stop-loss orders can help you predetermine exit points, reducing the chance of letting emotions dictate sell decisions?
Stocks with high short interest can be subject to 'short squeezes' if positive news triggers a rapid price increase?
Growth stocks often exhibit asymmetric risk, as their potential for substantial gains is counterbalanced by increased volatility and potential for steep losses?
Challenging your own investment beliefs periodically can ensure they are based on logic and not just habit?
If an investment has a negative beginning or ending value, CAGR might not be the best metric for evaluation?

Quotes of the Day:

"The key to successful investing is to be patient and wait for the right opportunities." - Julian Robertson
"Investing is about figuring out what something is worth and paying a lot less for it." - Bruce Berkowitz
"The investor who is not willing to do his own research is like a gambler who bets on a horse because someone else tells him it's a sure thing." - Irving Kahn
"The most important thing in investing is temperament, not intellect." - Christopher Davis
"The best investments are the ones that have a competitive advantage." - Mario Gabelli

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