Summary - Whether an investor practice fundamental analysis or technical analysis, one of the most important keys to success is buying low and selling high. For traders who are looking for technical indicators, one of the most significant to identify is a support level. A support level and its counterpart a resistance level appear as horizontal lines on a stock chart and help to define an area where buyers and sellers are finding agreement about the direction of a stock’s price movement.
Traders use historical information and chart patterns to predict future movement. Because in order for them to make a profitable trade, they need to focus less on where an asset is currently priced, but what direction it could be moving. When an asset hits a support or resistance level, it can serve as a trigger for investors. Experienced investors take advantage of the emotional response from investors who pile in at support and resistance levels because of the fear of missing out. At the support level, demand for the stock outweighs the supply. This limits the stock price from falling any further. In some cases, the support level is not a single line, but a series of prices that form a support zone.
A support level does not necessarily mean an asset is oversold. Many times an asset simply establishes a range and requires a significant event to change buyer and seller sentiment. Range trading is one of the most common ways for investors to trade support and resistance levels.
However, when assets breakthrough a defined support line, investors can still identify new levels of support as the stock will enter a retracement pattern where it tries to recapture the previous support level. If it is not successful, the asset will begin to exhibit a downward stair-stepping pattern where the lines of support and resistance will flip flop until the asset finds a new range.
Support and resistance trading is common in the forex market but can be used for virtually any asset class.
In order for traders to find profitable trades, they rely on correctly determining price moves. Investors who practice technical analysis believe that, although the price of an asset contains all relevant market sentiment, there are indicators that can provide guidance to future movement. The ability to successfully identify future price movement is the key to success.
One way of the technical indicators that novice and experienced investors can look for is a support level. When you bounce a basketball on the ground, the ground provides support for the ball and causes it to bounce back up. No matter how hard you bounce the ball, it will always come back. But what if the basketball were a bowling ball? And instead of bouncing it you just picked it up and dropped it on the ground? If that were the case, the combination of added mass plus the force it was dropped at could break through a previous level of support.
That rough analogy describes what happens with a support level. When an asset is trading in a range, buying and selling activity balances out and before selling pressure gets too intense, buyers jump in, lifting an asset off of its support level. This article will provide an overview of a support level that includes discussing why a support level is significant, how to look for new support levels when there is a breakthrough in price, and what additional technical indicators can be used to help identify support levels.
What is a support level?
A support level is a technical indicator of price movement. When an asset is said to be at a support level, it has reached a price floor. While it is not uncommon for an asset to eventually break through this level of support, a support level – once reached – can be tested many times before being affected by a downtrend.
When analyzing a daily chart, an asset’s support level is indicated as a horizontal line that will look like a “floor” for an asset price. Typically, an investor or trader will look to see at least two instances of an asset price being supported at a price level before presuming they have identified a support level. In some cases, a support level will be indicated as a series of lines that form a support zone.
The correlating indicator to a support level is a resistance level. This is indicated as a horizontal line that represents a “ceiling” at which prices are finding resistance. Support and resistance levels are commonly used in a range trading strategy. In this strategy, the support and resistance lines form a clearly defined channel. Buying occurs at or near the support level and selling occurs at or near the resistance level.
Why are support levels significant?
Technical analysis assumes that an asset’s current price already factors in all the news and other economic reports that may drive it up or down. The key is to identify where an asset’s price is going. That’s where a support level comes in. When a trader can identify a clear technical support level, they can have confidence that the price is going to start to move upward. Furthermore, when a support level also has a clear resistance level, the trader can identify a clear price point at which to exit the trade. With clear support and/or resistance levels, a lot of the emotion can be taken out of trading decisions. Traders can simply buy on the lows and sell on the highs.
The strength of a support level is influenced by factors such as trading volume, the number of times a support level has been tested, the time frame an asset has been at a support level, and the severity of the price movement that preceded the support level (i.e. was it sharp or gradual).
Establishing new support levels in changing markets
Up until now, we’ve been looking at support levels in the context of range trading, which is the simplest way to both understand and trade support and resistance levels. However, market conditions can drive stocks into an uptrend or downtrend. This is sometimes called dynamic price movement. During these periods, nimble traders can still identify levels of dynamic support and resistance. This is because of what is called retracement.
Retracement occurs when a stock breaks through a support or resistance level. When it breaks through a support level, the asset may try to reclaim the previous support level. This is called retracing. If it is successful, then traders may have experienced a false breakout. However, if it is not successful than the asset may be on its way to exhibiting the pattern of lower highs and lower lows that signify a downtrend. When this happens, the previous support line may now act as a level of resistance. This process may keep occurring until the price reaches a new “floor” that will act as support.
Conversely, if the price of an asset breaks above its resistance level, it may attempt to reclaim the previous level. Assuming it is not a false breakout, traders can assume that the asset is now in an uptrend. In this situation, the previous resistance level may now become the new support level.
Let’s consider an example:
Company ABC has been trading in a range of $20-$27. At the opening of trading, the stock price falls to $19.50, briefly climbs back to $19.90 but then continues to fall again but fails to fall below $19.50. Over the course of the trading day, this pattern repeats itself. $19.50 now becomes the new support level and $20 (or close to it) becomes the new resistance level.
However, what if after the stock tried to reclaim the $20 support level, it continued to fall only this time it took out the $19.50 price point and moved lower. In this case, traders would expect to see a declining stair-step pattern of lower lows and lower highs until the stock finds a new support level. At this point, a new resistance level may or may not be clear.
Now let’s look at the same example on the other end of the trade. At the opening of trading, the stock price rises to $27.50, briefly dips to test the previous resistance level, but then continues to rise again but does not crack $27.50. If the pattern continues, $27.50 becomes the new resistance level with $27 (or close to it) becoming the new support level.
In the same way, if after failing to fall below the $27 resistance level, it continued to rise above the $27.50 price point, then traders would expect to see a rising stair-step pattern of higher highs and higher lows until the stock finds a new resistance level. However, at this point, there may or may not be a clear support level.
Using other technical indicators with support levels
When an asset is undergoing dynamic price movement, it can be difficult to identify a clear support or resistance level. When this happens, traders can look at other technical indicators that can help them identify levels of support. Two of the most common of these indicators are trendlines and moving averages. In our example above, a trendline would connect all the new lows (in a downtrend) or highs (in an uptrend). When the new support or resistance level is reached the line would plateau which will be a visual cue to traders. Using a moving average can have a similar effect. A moving average is simply a calculation of the average closing price of an asset over a period of time. Although 20-day and 200-day moving averages are common, many variations are used. Some day traders may use hourly moving averages. As prices rise the moving average will slope upwards and as they move down, the moving average will slope downwards. Traders may use a combination of short-term and longer-term moving averages (e.g. 50-day and 200-day) and look for crossover areas (i.e. where the short-term crosses over the longer term and vice versa) as these occurrences can signify quality trading opportunities.
Another technical analysis tool that works with support level s is a Fibonacci retracement which is created by placing horizontal lines at areas where a price meets support or resistance at key Fibonacci levels before continuing in its original direction. These levels are created by plotting a trend line between a major peak and trough, then dividing the distance between the two by the following ratios (called Fibonacci ratios): 23.6%, 38.2%, 50%, 61%, and 100%. Because, unlike moving averages, Fibonacci retracements are static prices that do not change, some traders find them preferable when looking for prudent guidance that allows them to react to price changes.
The bottom line on support levels
A support level can be viewed as a visual representation of supply and demand is revealed through trader behavior. A support level is formed when buyers of an asset outnumber sellers, not allowing the price to fall any further and therefore providing a level of support otherwise called a floor. Traders use an asset’s support level as one indicator that can suggest a buying opportunity. Upon hitting a support level, a price can only do one of two things. If there are not sufficient external forces (a negative earnings report, heavy short selling, etc.) then the price will bounce off this level. Traders can use this as an opportunity to enter a long trade. When the price finds a resistance level, where sellers outnumber buyers, traders can take the opportunity to sell the stock, therefore, closing out the trade.
Price action around support and resistance levels can become very predictable. For investors who are comfortable with actively trading a range-bound asset, support levels help identify profitable trading opportunities. However, there are other times when an asset breaks out of its range. A breakthrough of a support level can leave investors on the wrong side of a long trade. However, because support levels are predictable when one is broken, traders can quickly identify it and take the appropriate action to get out of the trade.