How Stocks Build Support Levels

This column was originally published on RealMoney on July 27 at 11:52 a.m. EDT.

A while back a reader wrote to me in response to my July 15 article on semiconductors. J.D. wrote, "One thing I don't understand is how the support level is established. I would appreciate it if you could explain that to me."

I tend to receive a fair amount of questions about support and resistance. Most of them begin and end with the proper method of drawing trend lines. Let's confine the discussion to support levels and leave resistance for another day. The most common question concerns whether the intraday lows should be used as the reference point for drawing support lines, or just the open or closing price.

Many well-known and successful chartists believe that all price action is relevant. They'll use the very extreme "tails" of the price action as reference points for support. Most of the time, this doesn't work for me because of my particular approach to support.

I simply look for congestion -- price levels that have attracted a great deal of trading volume. These levels are where the most financial (and hence, emotional) commitment lies. If everyone buys at the same level, isn't it a bit easier to figure out what "the market" is feeling? If the price is higher than their buy point, they are happy. If it's too high, they'll probably start taking profits. And after they've taken profits, if the price falls back to where they bought, they're likely to buy again ... and be joined by those who were waiting in the wings for a second bite at the apple.

That's what makes support: the collective emotional commitment that is strong enough to bring about enough aggressive buying activity to absorb all the supply at that same level.

As long as the price action continues to bounce off that level, the bulls are winning the battle. But if the price action falls beneath that established support, then we know that the emotions of the crowd have shifted.

The crowd is no longer anxious to buy the stock at that level. They are tentative enough to wait for lower levels. And as the price declines, more and more folks who had bought at support give up. They cut their losses short, and that selling pressure puts more pressure on the price.

And if the stock returns back to that prior support level? Well, that's resistance, and it's caused by those stock holders who failed to sell on the last decline. Now, they're so darned happy to have a second chance to get out at close to "break even," they just dump the stock and walk away. That is the concept of "prior support becomes current resistance."

Now let's see if we can put this idea of support to work in some charts.

Comcast

With Comcast(CMCSK Quote), $29 is the level where buying interest was sufficient to soak up all the supply. I think the stock moves higher from here. But look at the "prior support" level in April through early June. It was at $31. So doesn't it stand to reason that a return to $31 will flush out a lot of slow movers who refused to sell at that level? So pay close attention to how Comcast acts when $31 is tested. A push higher is very bullish. But a stall in the uptrend at that level just means that more churning is needed to soak up all that regret that lurks in the hearts of those who are still holding with a $31 basis.

Kroger

This uptrending support line in Kroger(KR Quote) indicates ever-increasing aggression on the part of the buyers. Their patience for lower prices is non-existent. Instead, each little dip in price brings about more buying. So far, the buying pressure has exhausted itself at $20 -- resistance. But when the price finally does advance past $20, those who previously sold may want to jump back on the bandwagon. They'll buy again and have to pay up for the stock. After all, those who bought between mid-June and now will not be anxious to sell just yet. A $1 price increase just isn't enough to prompt profit-taking. So buyers will have to chase the stock higher. By the way, what happens if the buyers don't chase the stock higher? That's a "failed breakout," and is every bit as bearish as a successful breakout is bullish. A failed breakout indicates an obvious lack of demand for the stock.

Weingarten Realty Investors

There are many levels of support here in Weingarten Realty Investors(WRI Quote). But the first thing that jumps out at me is the overwhelming selling pressure lurking at $40. Shares just won't go higher. So what happens if the demand finally pushes the stock above this current resistance? Anyone who didn't buy will be hoping for the price to fall back to the prior breakout level -- so they can buy. If that occurs, then $40 will have become support.

W.R. Berkley

Notice the price action that created the support trend line from late June to last week. The bulls were increasingly aggressive, establishing a series of higher lows from $35.50 on the way up to $36. But support broke down and the stock fell. Bearish! However, this decline reversed within just a few days. The buyers had been asleep at the wheel, but they finally woke up and pushed the stock right back above the prior support line at $36, and even above the downtrending resistance line that was formed by ever-declining price peaks. So what had been a bearish development is now quite bullish. A stock that won't go down will typically go up.

Genentech

Genentech(DNA Quote) had been pulling back for the last week or so. But yesterday's price action remained above Monday's low. Buying interest was sufficient to establish support -- albeit only short-term support. Because this stock has been in an uptrend, this pullback looks buyable to me. But Monday's low bears watching. If there is not sufficient buying interest to keep DNA above that level, then I wouldn't be interested in buying it either.

Be careful out there.

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