Originally posted by: Special K
I don't understand the whole "resistance/support" thing. Are you saying that investors will be very hesitant to let a major index drop below its previous low value? That makes no sense to me. It seems like a purely psychological decision.
Then again, investors aren't rational and there is an entire field of academic study devoted to behavioral economics, so maybe this is just the way it is.
There are hundreds of books written about 'technical analysis' of stocks - as far as I can tell, it's basically astrology for stock markets. There's absolutely nothing underpinning it. However, it seems that enough people use the same signs and trade on them that they become a self-fulfilling prophecy.
Essentially, there are a number of basic predictions that technical analysis makes - if a stock price, or an index, or whatever has previously dropped and got stuck at a particular level. E.g. the dow on a number of recent down days has been sticking at about 8000, and for the last 3 times it hit, it stopped dropping as soon as it hit 8000, and reversed direction. If you plot a chart, it's like there's an invisible shelf there, that a bouncing ball will bounce off. This is a, so called, 'support'.
Why does this phenomenon occur? Presumably, it's because people like to buy stocks 'on the dips'. Rather than just blindly buying to add to a portfolio, they wait for the price to drop a bit, to shave a few % off the price. How do you know how far it's going to dip? Best guess is probably how much it dipped last time. If you believe in TA, then you might buy in, at that point, as it's likely that the stock price will start to go up.
The theory goes that if a stock price approaches support, then it will bring buyers in, and will tend to bounce off. However, every time it hits the support, it depletes buyers. Eventually, you run out of buyers, and the next time the stock hits the support it'll sail through, and there won't be any buyers to stop the price falling a good way. So, day traders who use TA, will often use this sort of signal to short a stock. The exact opposite is 'resistance'.
You wouldn't use these 'technicals' to make a long term, safe investment, but they are potentially helpful hints for gambling on stocks. These are often short term signs, although if you ask around, someone will quote some fractal symmetry stuff and say that it works over years as well as seconds.
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