Ask Colin

Are support and resistance levels on index charts valid?

The first answer is to consider that people do indeed trade the index. There are futures on the index and there is arbitrage between the futures and the physical market. However, while this is true, I doubt it is a complete answer. Indeed, the phenomenon was obvious on charts before futures markets came into existence. At most, the futures markets would reinforce the phenomenon, rather than cause it.

The next answer is to say that people do watch the index. And they do it in real time these days. The idea of support and resistance is that old highs and lows are known and that buyers and sellers watch them. So, when a market comes to previous high, buyers become apprehensive that sellers will again emerge. Indeed, they are bound to, because they will be aware that they missed the high last time and may be tempted to sell into it this time. So, the index levels affect the general psychology of buyers and sellers - they increase or decrease their commitment to the market at these levels.

The final answer is to say that the index is the sum of all the individual stock decisions. While there will not be perfect accord between individual stocks and the index, there is a general tendency. This is similar to the way most stocks rise or fall with the market, but to differing degrees. So, the index reflects overall market sentiment.

Lastly, I find that support and resistance levels are more precise on individual stocks than on indexes. Neither are perfect textbook behavior, but there seems to be more fuzziness on indexes. Futures and real time index data may be lessening this, but it does go towards your train of thought.