Support levels are a price area where descending security prices are expected to experience increased demand. A support level is formed when prices fail to descend further, and either enters a phase of congestion or institutes an uptrend. If a support level is validly penetrated, prices are expected to continue declining.
A support level is simply a price area where demand is expected to exceed supply. That being said, support levels are typically price areas where a trend has stalled, or reversed, in the past. Some indicators look to predict price areas where support might occur. Some are better than others. One of those indicators is the retracement percentage tool.
Trading at support levels is one of the most rudimentary analytical techniques, yet one of the most effective. Some analysts predicate their entire strategy on support and resistance trading.
Support levels could be psychologically significant numbers, areas where the price movement has failed to hold on multiple occurrences, and even retracement levels. The potential reasons why a stock experiences support at certain price levels are many. The catalysts above are just a few examples of what causes these levels to manifest.
Figure 1.1 Major Support Level
Figure 1.1 shows a major support level for $MSFT. Demand exceeded supply at the correlative price area, and sellers were unable to overpower buyers at the price area.
Trading at a major support level is an effective approach for a few reasons. A major level is likely to have formed on high volume, or, has remained in operation for quite a while. If strong buying occurs when prices test a major support level, we have a good chance at profit by entering long. Personally, I think the best advantage of trading major support/resistant points is the opportunity to mitigate losses quickly when the level is validly penetrated.
There are a few ways to distinguish a major support level from a minor support level.
A level formed on high volume is more significant than a level formed on low volume. A support level formed on high volume reflects considerable demand at the correlative price area. A support level formed on high volume will be difficult to surpass in the absence of stronger selling intensity.
Amount of Time Level was Traded
A level that prices trade at, or very near, before prices reverse is considered significant. A level that price trades at for two weeks is more important than a level traded at for two days. A level that price trades at for two months is more important than a level traded at for two weeks. This may not be the case every time, but more often than not it is. Let’s say a level is formed and traded at for a few days. Instinctually, this may not seem like a significant level; however, the level was formed on high volume. Even though the level formed and was traded for a few days, the high volume trading constitutes major support (demand). For prices to trade at a support level for an extended period of time: buyers and sellers must be in a battle each successive session.
Time Since Level was Traded
Time since a support or resistance level was traded is another factor in determining the magnitude of a support level. A level recently formed was actively traded not long ago. Recently formed levels are usually more significant than levels formed before them; however, this is not always the case. Let’s say a support level is traded for two months. Price subsequently increases, halts, and a resistance level is formed. In this case, the newly established resistance level was most recently traded. This does not mean the newly established resistance level is more important than the long-established support level. You must account for all three factors when distinguishing a level as major or minor. Volume, amount of time a level was traded, and amount of time since a level was traded must all be assessed.
Let’s say stock XYZ were to rally up to the $200 level and then experience low volume while prices gradually fall back under the $200 level, this could be considered minor resistance.
Let’s assume that stock XYZ is trading at $395 and then rallies upwards to $400. At the $400 level, XYZ trades sideways with relatively high volume and validly penetrates the $400 level to the upside. Whether this takes days or weeks, the high volume sideways price movement at this level may lead to strong support in the future should stock XYZ ever re-test the $400 zone again.
Minor Support Levels
Let’s dial-in on support and resistance levels which form during a trend. These levels are typically minor.
Figure 1.2 Support and Resistance Levels – Stalls and Reversals Uptrend
Figure 1.2 depicts a healthy uptrend with peaks and troughs. Each price peak forms a resistance level. Each price trough forms a support level.
For prices to sustain an uptrend; higher peaks and higher troughs are necessary, particularly higher troughs. Each peak formed during an uptrend constitutes a resistance point. Why? Well, prices reached a peak and then moved against the uptrend (bearish retracement). Selling intensity, whether due to profit-taking or short-selling, exceeded buying intensity at the peak price. Price peaks preceding a bearish retracement are typically minor resistance areas and are validly penetrated with ease during a strong uptrend. The final peak formed during an exhausting uptrend, prior to a complete change in trend, is likely to perform as major resistance if tested in the future.
The marked support levels in the illustration reflect termination of the bearish retracement, and the institution point of continuation for the uptrend. Think of it this way. An uptrend in motion requires demand > supply continuously. Due to natural supply/demand dynamics, there will be times in the uptrend where prices fall (bearish retracement). During a strong uptrend, this is likely due to position holders (buyers) closing their positions (selling their shares to the market for profit), and contributing to supply. Be sure to pay attention to the next sentence. When bullish sentiment and demand are strong, traders are eager to “buy the dip”. When an uptrend is strong, bullish sentiment is strong, traders are looking for opportunities to enter the uptrend. This lays the foundation for retracement percentages (discussed later in the chapter). We can evaluate the momentum/strength of an uptrend by identifying the percentage amount prices fall before continuing the trend. If traders are “buying the dip” expeditiously; prices will not “dip” to a large degree before continuing the uptrend. If so, we should conclude demand is strong, and the uptrend is likely to persist. We will dial-in on this later.
Figure 1.3 Support and Resistance Levels – Stalls and Reversals Downtrend
Figure 1.3 depicts a healthy downtrend with troughs and peaks. Each price trough forms a support level. Each price peak forms a resistance level.
For prices to sustain a downtrend; lower peaks and lower troughs are necessary, particularly lower peaks. Each trough formed during a downtrend constitutes a support point; prices reached a low and then moved against the downtrend (bullish retracement). Buying intensity, whether due to profit-taking or share buying, exceeded selling intensity at the trough price. Price troughs preceding a bullish retracement are typically minor support areas and are validly penetrated with ease during a strong downtrend. The final trough formed during an exhausting downtrend, prior to a complete change in trend, is likely to perform as major support if tested in the future.
The marked resistance levels in the illustration reflect termination of the bullish retracement, and the institution point of continuation for the downtrend. A downtrend in motion requires supply > demand continuously. Due to natural supply/demand dynamics, there will be times in the downtrend where prices rise (bullish retracement). During a strong downtrend, this is likely due to short-position holders (sellers) buying back their positions (buying back the borrowed shares at a cheaper price for profit), and contributing to demand. When bearish sentiment and selling intensity are strong, traders are eager to “sell the bounce”. When a downtrend is strong, bearish sentiment is strong, traders are looking for opportunities to enter the downtrend. Again, we can evaluate the momentum/strength of a downtrend by identifying the percentage amount prices rise before continuing the trend. If traders are “selling the bounce” expeditiously; prices will not “bounce” to a large degree before continuing the downtrend.
Figure 1.4 Support and Resistance Levels – Downside Reversal
Figure 1.4 depicts an uptrend in which the second resistance point was not validly penetrated. Price instead decreased and validly penetrated the second support level, signaling a potential change in trend.
When a price sequence similar to figure 3.3 occurs, the uptrend may be in trouble. For this to occur, demand is no longer exceeding supply continuously. The valid penetration of the second marked support point in the illustration is critical to observe in a live market. When this occurs, we need to ask “Why is demand no longer strong enough to exceed selling intensity at a price area where it previously exceeded selling intensity?”.
The resistance point which was not violated to continue the uptrend is likely to function as major resistance in the future, especially if the level is an all-time high price for the underlying security.
Figure 1.5 Support and Resistance Levels – Upside Reversal
Figure 1.5 depicts a downtrend in which the second support level was not validly penetrated. Price instead increased and validly penetrated the second resistance level, signaling a potential change in trend.
When a price sequence similar to figure 3.3 occurs, the downtrend may be in trouble. For this to occur, selling intensity is no longer exceeding demand continuously. The valid penetration of the second marked resistance point in the illustration is critical to observe in a live market. When this occurs, we need to ask “Why is selling intensity no longer strong enough to exceed demand at a price area where it previously exceeded demand?”.
The support point which was not violated to continue the downtrend is likely to function as major support in the future.
Figure 1.6 Support and Resistance Levels – Stalls and Reversals
In Figure 1.6, stalls and reversals are marked which can be classified as support and resistance levels. Notice how the marked support and resistance levels consist of a line and an oval. The line indicates the exact price level where support or resistance formed. The oval indicates where prices are likely to stall or reverse if the same support or resistance level is tested again and momentum fails. For support levels, the bottom portion of the oval, below the line, indicates where prices may penetrate the level before stalling or reversing. Remember, prices can slightly penetrate a level before stalling or reversing. We are focused on identifying valid penetration. If prices validly penetrate the level (exceed the oval), it is likely the price move will continue. For resistance levels, the upper portion of the oval, above the line, indicates where prices may penetrate the level before stalling or reversing. Again, valid penetration is our primary concern.
As previously mentioned, support and resistance levels are established for various reasons. In Figure 3.5, the marked support and resistance zones were contingent on stalls and reversals due to increased buying intensity during a price decrease and increased selling intensity during a price increase. However, the marked levels are all minor.
In Figure 1.6, the price movement of $BAC tested and failed twice near the $25 price level. I marked both of these failures as resistance points. Similarly, $BAC found support near the $20 price level, as indicated by the early March and mid-April ovals that are marked “support.” Eventually, price movement did validly penetrate the $25 resistance point. $BAC then failed to sustain these relatively high price levels and gapped back down.
Backtesting Support Buying and Resistance Selling With an Oscillator
Let’s run a few backtests on range-bound markets governed by a major support and resistance level. We will use an oscillator to complement our system.
Figure 1.7 Backtesting Support
Figure 1.8 Backtesting Support
Figure 1.9 Backtesting Support
Practical Use – Straight Talk
Buying at a support level is a simple and effective strategy, primarily because we can close a losing position quickly if the level is validly penetrated. Therefore, buying at a major support level is a lower-risk opportunity to enter the market.
Excluding retracement percentages, it’s ill-advised to buy at minor support levels. We can’t definitively conclude there is strong demand at the correlative price area to cause an exploitable change in trend.
Sideways markets are usually bound between a major support and resistance level. When a market is range-bound such as this, supply (selling) and demand (buying) are at equilibrium – neither force is dominant enough to institute a sustainable trend. This particular market condition offers the best opportunity to buy at a major support level.
Check out this Youtube video to understand why.
When buying at a pre-established support level you’re anticipating demand to exceed supply at a price area where it’s done so before.
Of course, a support buying strategy should be a constituent of an overarching comprehensive trading strategy.
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