If the market or a stock price can’t seem to go above or below certain points, resistance & support levels can be identified. For example:
When this stock starts approaching $50, it reverses back down. This is known as the resistance level ($50 in this example). When it approaches $40, it reverses back up. This is known as the support level ($40 in this example). As we learned earlier in this subchapter, this is an example of a consolidating market, which results in difficulty assigning a market trend. While in the middle of the resistance and support levels, a neutral strategy (like covered calls or short straddles) could be profitable.
A breakout would have to occur for a bullish or bearish trend to be identified. Here’s an example of an upside breakout:
When a breakout occurs, stock prices tend to continue moving in that direction. It can be assumed thousands of investors could be watching these market movements, which creates a self-fulfilling prophecy. When stock prices rise above resistance levels, investors attempt to “jump on the bandwagon,” buy the stock, and ride it upward. An influx of demand will lead to rising market prices. Therefore, an upside breakout is a bullish indicator.
A downside breakout looks exactly the opposite:
Again, a breakout trend tends to continue in the same direction. When stock prices fall below support levels, investors attempt to “jump off the bandwagon” and sell stock to avoid future losses. A more savvy technical analyst might even sell short the stock and profit if the market continues to fall. When investors see the downside breakout, usually an influx of supply (sales of that security) drives down the price, pushing it down even further.
In the secondary markets chapter, we’ll discuss what types of orders investors can place to benefit from an upside or downside breakout.
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