When you look at a stock chart, you can spot resistance levels: previous highs in the stock chart. As the price approaches those highs once again, it may encounter a sell-off as investors decide it can't go any higher. However, resistance doesn't always mean the stock will go back down. You have to develop a knack for knowing when a stock may be due a decline and when it may break through resistance and go higher.
Why Resistance Points Resist
Every stock trade has a seller and a buyer. That means at a peak in the stock's price, somebody bought it. That person has experienced a decline in the stock, and if he holds onto it, he will be ready to sell as the stock approaches the price he bought it for. This is resistance. When the stock price reaches the peak price, sellers may dump it and drive the stock price back down. If this worked every time, you would know for certain when to sell the stock as it approaches resistance. However, some news about the company's prospects can increase demand and overcome the resistance level.
If a stock hits resistance and falls slightly in price, you can check the volume of that pullback. Stock charts usually show a bar at the bottom that indicates the strength of the volume for each day's trading. You can compare the height of that bar to other bars in the chart to see if it is above or below average. Light volume on a pullback may indicate that only a few sellers stepped in, and buyers could push the stock price higher with increased demand.
A stock that pulls back slightly on light volume can break through resistance. A true breakout usually happens on higher-than-average volume. You often see a breakout when a stock has approached resistance two or more times and then pulled back. This means those who want to sell have had several opportunities. When there are no more sellers for a stock, it goes up in price.
When Resistance Becomes Support
If a stock breaks through resistance, the old resistance level may become a support level. You can watch to see if the stock pulls back after a breakout. If it does, the old resistance price may be where buyers come back in and drive the stock price higher. Bargain hunters may be waiting on the sidelines, regretful that they didn't buy the stock as it approached the old resistance level.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.