Support, resistance and trendlines: reading a chart without fooling yourself

A price chart is a record of what people were willing to pay. It’s not a crystal ball, but if you know how to read it, it’s a useful map of where others have made decisions.

Support and resistance, at the sabzi mandi

Support is a price zone where falling prices have tended to stop, because buyers have stepped in. Resistance is a zone where rising prices have tended to stall, because sellers have appeared.

Two words in those definitions matter: “zone” and “tended”. Support at ₹1,000 doesn’t mean ₹1,000.00. It might mean ₹985 to ₹1,015. And it can give way at any time, as the tomato price would if a bumper harvest arrived.

Trendlines

A trendline connects a series of swing lows in a rising market, or swing highs in a falling one. Together, two parallel lines form a channel.

There’s a live version on my homepage, which prints candle by candle as you scroll. That’s illustrative data too.

Three habits make trendlines more honest:

1. Require more than two touches. Any two points make a line. A third touch that holds gives the line some meaning.
2. Draw before you decide. It’s easy to draw a line that supports what you already want to do.
3. Allow some give. A wick poking through a line doesn’t necessarily mean it’s broken. Decide in advance what would count as a break, such as a close beyond it.

Breakouts and false breakouts

A breakout is when price moves beyond a resistance or support zone. The idea is that the balance between buyers and sellers has changed.

Many breakouts fail, though. Price pokes above resistance, attracts buyers, and falls back. To judge one, analysts commonly ask:

• Did it close beyond the level? Or did it just touch it during the day?
• Was volume higher than usual? A move with heavy volume suggests more participation.
• Did it hold? Sometimes old resistance becomes new support, and a retest that holds adds some confidence.

Volume and moving averages

Volume is how many shares traded. It tells you how many people took part in a move.

A moving average smooths out the daily noise by averaging recent closing prices. An exponential moving average (EMA) gives more weight to recent days. A rising price above a rising average is one simple description of an uptrend. Note that it’s a description. Averages are built from past prices, so they lag by design.

Five ways to fool yourself

1. Seeing patterns everywhere. Our brains find shapes in random data, as they do in clouds.
2. Hindsight. Patterns look obvious once the outcome is known. Try covering the right side of a chart and calling it honestly.
3. Only remembering the wins. Keep a record of every call, including the ones you’d rather forget.
4. Moving the line. If you redraw a trendline each time price breaks it, it isn’t telling you anything.
5. Ignoring the business. A clean chart can sit on top of poor results, and a results surprise can erase any pattern overnight.

How I think about combining charts with fundamentals

I find it useful to treat them as answers to different questions.

The most useful habit in any of this is the last row of that table. Before acting on any view, write down what would make it wrong. That’s worth more than any pattern.

Price action

Maksud Ahmad Khan

Finance fresher and NISM Series XV Research Analyst, on the PGPM at ICFAI Business School, Mumbai. I write about IPOs, filings and Indian markets. Say hello.