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[Shaw] One of the most important aspects of technical analysis involves the judgment of so-called support and resistance levels. Often one reads about a stock that is selling, let us say, at 36, having support at 28-30, with potential overhead resistance at 43-45. Just what is the writer talking about?

Let us assume that you have been following the price movement of a certain stock that has been trading for a period of time in a neutral fashion - or fluctuating between the levels of 26 and 30. Obviously, during the neutral price movement the forces of supply and demand have been fairly equal. Ultimately the stock will break out of this consolidation pattern in either an upward or downward direction. If the direction is upward, thus indicating a surge of demand, a distinctive clue would be given that the on-balance activity that most likely occurred during the consolidation phase was accumulation rather than distribution (see Assumption 2). Let us assume you made a commitment in the stock in the 26-30 zone prior to the upside breakout. Often an investment "story" is not bought by all on the first go-round. Some extra convincing is necessary. Such convincing can be accomplished by the mere price performance of the stock itself. In the illustration above, the stock has just moved up in price as profiled by the breakout from the consolidation phase. Let us assume that some adverse external news comes to the fore, and the stock experiences some minor selling pressure, falling back to the area of the original price consolidation. Chances are quite good that those who purchased shares initially would not now be sellers of the stock. In fact, they may even be inclined to buy more. And, of added importance, investors who did not purchase the shares initially may now seize upon this second opportunity to make a commitment. The motivations just discussed are primarily predicated upon (1) the recent price activity in the stock, during which it was just selling at the higher price after breaking our of the consolidation trend and (2) a feeling of confidence, to a degree based on this price action, that the stock will eventually resume its upward trend. It is mainly because of these psychological factors that market analysis would anticipate that the stock in question should find support between 26 and 30. At least initially, there is a good chance of the stock bouncing back up. Thus, by definition, a support level is a phase of price consolidation - or congestion - below the current quotation of a stock. Utilizing Assumption 3 for a minute, the extent of the lateral consolidation often has a bearing on the validity of the support. Minor consolidation suggests a minor support level, where a more elongated congestion zone would suggest major support.

It should now be simple to explain resistance (or supply). Let us say your investment made between 26-30 turns out to have been an error in judgment. Instead of the stock moving up, it breaks down out of the congestion pattern, reaching a level of 20. Mass psychology now begins to work quite differently. Rather than taking the opportunity to buy more shares at the current cheaper price, many investors will simply bemoan their mistake and hope for a chance to break even. This psychological behavior suggests that on any strength back into the overhead consolidation area, the stock will meet supply, or sellers will dominate. Whereas in the first example you did not buy the stock to break even, in the latter case you are hoping that a break-even position can be attained. Thus, by definition, a resistance zone is an area of price activity above a stock's current quotation. The influence of the resistance may well depend upon the duration of the consolidation pattern.

Currency Orders and Exchange-Rate Dynamics: Explaining the Success of Technical Analysis, Osler, 2001
This paper provides a microstructural explanation for the success of two familiar predictions from technical analysis: 1) trends tend to be reversed at predictable support and resistance levels, and 2) trends gain momentum once predictable support and resistance levels are crossed.
Support for Resistance: Technical Analysis and Intraday Exchange Rates, Osler, 2000
"The results indicate that intraday exchange rate trends were interrupted at published support and resistance levels substantially more often than would have occurred had the levels been arbitrarily chosen".
Number Preference in Australian Stock Prices, Chris Doucouliagos, 2000
"Stock price rallies/declines often terminate at price levels that are interpreted by many as areas of psychological resistance or support, while an alternative interpretation is that they coincide with price clusters. Some of these price levels tend to repeat with a regularity that is inconsistent with mere chance. In this paper, the existence of price clusters and psychological barriers is tested on a sample of 20 Australian stocks. We consider two number sequences, both derived from a base number of 100, as well as integer price levels. It is shown that Australian stock price data are not uniformly distributed and that for the majority of the stocks, price swing highs and lows are associated with certain recurring price levels. Some of the implications for trading and investing are considered".
Technical Analysis and Liquidity Provision, Kavajecz and Odders-White, 2002
"We find evidence consistent with the hypotheses that support and resistance levels coincide with peaks in depth on the book...".
Psychological Factors and Stock Option Exercise, HEATH, 1999
"Consistent with psychological models of values that include reference points, employee exercise activity roughly doubles when the stock price exceeds the maximum price attained during the previous year".
Technical analysis in the Madrid stock exchange, Rodriguez, Rivero and Felix, 1999
"In this paper we assess whether some simple forms of technical analysis can predict stock price movements in the Madrid Stock Exchange. Our results provide strong support for profitability of these technical trading rules".