Source: Yahoo Finance
Support & Resistance
Support is a price at which a financial security finds a base. From this base, the price of the financial security may go up.
Resistance on the other hand is a price at which a financial security finds a ceiling. From there, the price of the financial security may move downwards.
The general idea is to buy near the support as the price moves up and sell near the resistance when the price of the security encounters difficulty is moving up further.
Some traders allow the security’s price to test resistance level before selling. If the resistance is broken, the trader may allow the security to run higher, thereby earning more profits.
Some traders initiate a short position at or around the resistance with the intention to buy it back at support. Option traders can use buy put options instead of dealing directly with the security concerned. Or he could initiate a bearish position on the underlying security. The trader may allow the security’s price to test support. If support is broken, the trader may continue to let his profits increase.
If support is broken, the security’s price can continue downwards. If resistance is broken, the security’s price can continue to move upwards.
A fake is a scenario where:
- The price of a security breaks above resistance and then falls back down
- The price of a security breaks below support and then moves back up
Fakes occur because market participants such as specialists and market makers deliberately drive the price to a level where there are lots of sell stop orders or buy stop orders. When the price reaches these levels, there is a sudden break above resistance or below support. While all these is happening, specialists are busy selling ( above resistance) or buy (below support) to drive the prices to trade between support and resistances levels. By doing so, these participants can earn a profit. These breaks above resistance or below support usually occur with increased volumes and occur for a short time period of 30 minutes.
How should option traders react to support and resistance levels?
- Initiate a bullish position at around support levels as the price swings upwards
- Initiate a bearish position at around resistance levels as the price swings downwards
- Initiate a bullish position as the price breaks strongly above resistance levels
- Initiate a bearish position as the price breaks strongly below resistance levels
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