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Precious metals investment terms A to Z

Resistance level

Resistance level is a key concept in Technical Analysis that is very helpful in determining the right moment to sell in an uptrend or to sell short in a downtrend.

Eric asks:

Eric and John are enjoying their coffees in a local café.

John, the Trader

John, the Trader

Oh, I just love muffins, can’t resist the temptation of getting another one.
Eric, the Beginner

Eric, the Beginner

Ha-ha, then get it! By the way, speaking of resisting temptations, it reminds me that I’ve stumbled on “resistance” somewhere in the financial press recently. What is it exactly? I bet it doesn’t have much to do with resisting temptations.
John, the Trader

John, the Trader

Well, you could say it’s about the price resisting the temptation of going up any more, ha-ha. But seriously, it’s simply a name for tops (both short- and long-term ones) on a price chart or – put the other way – the price at which the selling interest is strong enough to overcome buying pressure and push the price lower. So on a chart it looks as if the price bounces off some invisible “ceiling” that prevents it from rising any further.
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It is the price level at which the selling interest is strong enough to overcome buying pressure and push the price lower. Thus, resistance is visible on the chart in the form of tops – these take shape precisely because of the existence of resistance. Resistance usually refers to the previous peak and that previous peak is quite often assumed to be the future resistance level. A resistance line is a line that connects previous peaks – it is an estimate of the future resistance levels. The chart below presents an example of a resistance line (charts courtesy of http://stockcharts.com/):

Miners:Industrials resistance line

The psychology of resistance

The formation of resistance levels is rooted in human psychology. To illustrate this notion, let us divide the market into three groups of people: the buyers, the sellers, and the uncommitted. Let us further assume that after some time of price moving sideways, it starts to fall. The ones on the short side of the market are happy, yet regret not having sold more. Should an opportunity arise (i.e. should the price return to that resistance level) they could increase their commitment. The ones on the long side of the market realize they made the wrong decision and are hoping that the price will go up to the place where they entered the market so they could liquidate their positions. Finally, the uncommitted see that a new downtrend (be it short or long term one) has begun and are waiting for the next good opportunity to sell short. So when the price finally rises their concerted effort is strong enough to push it downwards after reaching the resistance level.

Determining the strength of a resistance level

The significance of a resistance level can be measured in three ways:

  1. Time spent in the resistance area – the greater it is, the more important that area becomes.
  2. Volume – the greater it is, the more significant the resistance level is. That is because heavy volume indicates bigger interest in that area and corresponds with more people participating.
  3. How recently the trading near the resistance level took place – the more recent the trading, the more significant the resistance level is. It is because people remember recent events more clearly and in a more vivid way, and since the formation of resistance depends on people’s feelings and emotions, this factor is quite important.

Falling and rising resistance lines

So far, only horizontal (or nearly horizontal) resistance lines were considered. But once a downtrend has begun, it is often impossible for the price to return back to the point where it begun to fall in the first place. And in an uptrend consecutive resistance levels are usually higher and higher. This is why trendlines (in downtrends) or channel lines (in uptrends) are often used as support lines.

A down trendline is a line that connects (at least two) crests in a downtrend. Once a down trendline is established, it is treated as a resistance line. A chart below shows an example of a down trendline acting as a resistance line:

Shanghai Stock Composite Index Falling Resistance Line

A channel is an extension of the trendline technique. Sometimes price trend between two parallel lines, one of which is the trendline – these lines are said to form a channel. In an uptrend, a trendline is constructed by joining the successive troughs, hence the parallel channel line joins the consecutive peaks. And this line may serve as a resistance line in an uptrend. An example of a channel is presented below: 

Gold's Uptrend Channel Serving As Resistance

Retracement levels as resistance

Another way of finding future support lines in the market is the idea of retracement levels. This notion stems from the observation that after a move in the direction of the prevailing trend, the price tends to retrace some part of it. The breadth of this correcting move depends mostly upon the strength of the main trend. There are various popular sets of these retracement levels, two of which seem to be employed most often: 33%, 50%, 66% and 38.2%, 50%, 61.8%. The latter group is called Fibonacci retracement levels and seems to be slightly more accurate than the first one. An example of Fibonacci retracement levels can be seen on the chart below:

Fibonacci Retracement and Silver

Resistance line penetration and role reversal

If a resistance line is penetrated by a significant amount, it becomes a support line, i.e. a line off which the price is more likely to bounce than to cross it from above – it is a concept contrary to the one of resistance. The same psychological factors (such as grief and regret) as in the formation of resistance play an important role in this case. An example of a resistance line becoming a support line can be seen in the above chart.

Verification of a breakout

In order to consider a violation of a resistance line valid, at least one of the criteria listed below should be met:

  1. The move below the resistance line should be significant. There is no clear rule telling what constitutes a significant move. Some use 3% as a benchmark in case of important resistance levels and 1 % in the short-term ones.
  2. It should be accompanied by high volume
  3. Price should close above the resistance level for 3 constructive trading days to confirm the breakout.

Conclusion

The idea of resistance is a fundamental one in technical analysis. It can be very useful in making investment decisions as it allows a trader and an investor to predict certain market moves. 

tops prediction corrections in gold

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