Think of security prices as the result of a head-to-head battle between a bull (the buyer) and a bear (the seller). The bulls push prices higher and the bears push prices lower. The direction prices actually move reveals who is winning the battle.

Using this analogy, consider the price action of Coca Cola in Figure . During the period shown, note how each time prices fell to the $40 level, the bulls (i.e., the buyers) took control and prevented prices from falling further. That means that at the price of $40, buyers felt that investing in Coca Cola was worthwhile (and sellers were not willing to sell for less than $40). This type of price action is referred to as support, because buyers are supporting the price of $40.

Similar to support, a "resistance" level is the point at which sellers take control of prices and prevent them from rising higher.  Note how each time prices neared the level of $42, sellers outnumbered buyers and prevented the price from rising. The price at which a trade takes place is the price at which a bull and bear agree to do business. It represents the consensus of their expectations. The bulls think prices will move higher and the bears think prices will move lower.

Support levels indicate the price where the majority of investors believe that prices will move higher, and resistance levels indicate the price at which a majority of investors feel prices will move lower. But investor expectations change with time! For a long time investors did not expect the Dow Industrials to rise above 1,000 (as shown by the heavy resistance at 1,000 in Figure ). Yet only a few years later, investors were willing to trade with the Dow near 2,500.

When investor expectations change, they often do so abruptly. Note how when prices rose above the resistance level of Hasbro Inc. , they did so decisively. Note too, that the breakout above the resistance level was accompanied with a significant increase in volume.

The development of support and resistance levels is probably the most noticeable and reoccurring event on price charts. The penetration of support/resistance levels can be triggered by fundamental changes that are above or below investor expectations (e.g., changes in earnings, management, competition, etc.) or by self-fulfilling prophecy ( Investors buy as they see prices rise). The cause is not as significant as the effect--new expectations lead to new price levels. Traders' remorse.

Following the penetration of a support/resistance level, it is common for traders to question the new price levels. For example, after a breakout above a resistance level, buyers and sellers may both question the validity of the new price and may decide to sell. This creates a phenomena I refer to as "traders' remorse" where prices return to a support/resistance level following a price breakout.

Consider the breakout of Phillip Morris in Figure. Note how the breakout was followed by a correction in the price where prices returned to the resistance level.

The price action following this remorseful period is crucial. One of two things can happen. Either the consensus of expectations will be that the new price is not warranted, in which case prices will move back to their previous level; or investors will accept the new price, in which case prices will continue to move in the direction of the penetration. If, following traders' remorse, the consensus of expectations is that a new higher price is not warranted, a classic "bull trap" (or "false breakout") is created.

As shown in the Figure, prices penetrated the resistance level at $67.50 (luring in a herd of bulls who expected prices to move higher), and then prices dropped back to below the resistance level leaving the bulls holding overpriced stock.

Similar sentiment creates a bear trap. Prices drop below a support level long enough to get the bears to sell (or sell short) and then bounce back above the support level leaving the bears out of the market.

A good way to quantify expectations following a breakout is with the volume associated with the price breakout. If prices break through the support/resistance level with a large increase in volume and the traders' remorse period is on relatively low volume, it implies that the new expectations will rule (a minority of investors are remorseful).

Conversely, if the breakout is on moderate volume and the "remorseful" period is on increased volume, it implies that very few investor expectations have changed and a return to the original expectations (i.e., original prices) is warranted. Resistance becomes support. When a resistance level is successfully penetrated, that level becomes a support level.

Similarly, when a support level is successfully penetrated, that level becomes a resistance level.

An example of resistance changing to support is for Procter & Gamble. When prices broke above the resistance level of $45.00, the level of $45.00 became the new support level. This is because a new "generation" of bulls who didn't buy when prices were less than $45 (they didn't have bullish expectations then) are now anxious to buy anytime prices return near the $45 level.

Similarly, when prices drop below a support level, that level often becomes a resistance level that prices have a difficult time penetrating. When prices approach the previous support level, investors seek to limit their losses by selling.

The following is a very brief review of the support/resistance concepts discussed in this section.