This is part nine of a series on technical analysis, specifically support levels. Click here for the series overview in part one. Click here for part two on the history of technical analysis. Click here for part three on an overview of candlestick charts. Click here for part four on basic candlestick patterns. Click here for part five on advanced candlestick patterns. Click here for part six on Bollinger Bands. Click here for part seven on trend lines. Click here for part eight on Fibonacci retracements. Click here for part nine on moving averages.
Two of the most important concepts to understand in technical analysis are support and resistant levels. They go hand in hand, with the support marking a sort of floor for a security’s price and the resistance marking a ceiling. We’re devoting an entire article to each of them because of how important these two elements are for technical analysis.
What is a support level?
The support level is the price a security doesn’t fall below over a certain period of time. Support levels can be seen as the lowest level traders will allow a price to fall to. Basically, as soon as the price reaches the support level, investors see it as a good opportunity because they expect the price to keep bouncing off that level. The price represents an area of concentration in demand, so any short-term downtrend will typically pause at that level, unless something else is impacting the price.
For example, in the case of stocks, investors buy more shares when the price hits a support level. Short-term investors will then sell those shares when the price hits the resistance level, assuming that they have climbed as much as they’re going to climb. In some cases, the stock will drop below the support level, which is another indicator we will discuss further below.
Support levels are often seen as a sort of psychological barrier because investors won’t allow the price to drop below them. Support levels often are marked at round numbers because when traders are placing target prices or stop orders for a security, they name a round number like $25 rather than dollar and cents like $25.02. Because there tend to be so many orders set for round numbers, support often finds a level at an even number because traders have decided that a security shouldn’t be worth any less than that particular price.
How to identify a support level
Support levels are marked on trading charts by drawing a line connecting the low points in a price. These lines can also double as trend lines because they enable traders to see which direction the price is trending in.
In the case of range-bound securities, the support level will be a consistent price it repeatedly bounces off, forming a horizontal line on the trading chart. However, when trend lines are identified, the support level will be diagonal in either an upward or a downward slanting trajectory. In this case, the support level isn’t the exact same price over a period of time. Instead, it will change gradually as the price trends in a generally upward or downward direction. Each low in the support level will be gradually higher or lower than the low that came right before it as the price trends in either direction.
Support levels can also be viewed with moving averages or other technical indicators which assist in reading and interpreting them. As explained in a previous article in this series, moving averages are designed to smooth out some of the volatility in a price by taking the average prices in a series and eliminating individual trades. The moving average can often serve as either a support or a resistance level, depending on whether the price is generally trending downward or upward. When the price is generally moving up, the moving average can serve as a support line because the security tends to hit the average and bounce above it.
Moving averages can be used as support lines to predict when the price is going to hit bottom and start to rise again. However, when the price breaks below the support line, it signals that a new downtrend may be taking over. There is no one single moving average that may be used as a support line. Some traders may find that the 20-day simple moving average is serving as a support line, while others may experiment and discover that another security is bouncing off its 50-day moving average as a line of support.
What to think about when interpreting support levels
Once you have identified an asset’s support level, you can interpret it in different ways. One of the most important things to understand when interpreting a support level is that the more often that level is tested, the more significant it becomes. For example, a support level that has been tested 12 times is of much greater significance than one that was only tested four times.
Another factor to take into account when considering the significance of a particular support level is the price move that came just before it. If the price suddenly dropped off sharply but stopped at the support level you identified, it essentially confirms that the asset has support at that level. A sudden drop tends to attract more attention than a slow, steady fall, so it’s especially significant when the price drops sharply and then stops suddenly.
One other thing to consider when studying support levels is the trading volume. The more buying that occurs at the support level, the stronger that support level is.
What to do with support levels
Before setting any buy or sell orders for any security based on a support level you have identified, you should make sure you understand the trend that’s happening. In the case of a range-bound stock, you may want to place a buy order right at the support level. This enables you to buy the stock when its at its lowest point in the range and then plan to sell it when it reaches the resistance level on the high end.
However, it’s important to remember that support levels are not hard, fast rules. Headlines, macroeconomics and other factors can always adjust the support higher or lower, and you won’t know it’s happening until after the price has broken below the price where the previous support was. Any break below the support level you have identified is a sign that a new pattern is emerging and that prices are now downshifting from where they were trading before. In this case, the support level often becomes a new resistance level marking the top of a new downtrend.
The next article in this series will focus on resistance levels and how to interpret them and use them to make trades.