Why Price Support Matters: Technical Analysis 101

BALTIMORE (Stockpickr) -- Everybody knows that all you need to do to make money in the stock market is "buy low and sell high," right?

Ha. If only it were that easy.

While that may not be the most actionable investment wisdom, it does identify what you should be focusing on. If you know how to spot price floors and ceilings, then you're better-equipped to make money in these markets than the vast majority of investors. Today, let's focus on the first part: buying low.

To do that, we're taking a closer look at how stocks find support, one of the keystones of technical analysis. How can different types of price support help you bank extra trading profits?

Support is one of the biggest concepts in technical analysis. Essentially, support is an area that a stock's share price has difficulty moving below -- a sort of price floor. (The opposite of support is known as resistance.) Support is significant because it provides traders with insight on when to pull the trigger on a trade as well as how to minimize downside risk.

Since stocks are at a short-term low when they reach their support levels, buying stocks at support provides an investor with lower entry prices and potentially higher profits. And since support is a sort of "price floor" for a stock, placing stop losses right below support helps mitigate risk when a stock makes a high-percentage fall through that floor (something known as a breakdown).

Support levels rarely appear at arbitrary prices. Instead, investor psychology and trading mechanics tend to drive this impressive chart phenomenon. Because of that, we have some tools we can use to spot it.

First, it's important not to discount psychology. Support levels frequently occur at price levels where high-volume buying took place. That's because when a stock slides down to a price at which many investors bought, investors who felt that those levels were attractive prices originally will often re-up their positions en masse, adding bullish pressure to the stock's price and halting the slide at a technical support level. Psychology can impact a stock at seemingly random price levels too. When the S&P 500 falls down to a major round number such as 1,000, investors often cool their selling pressure.

Trading mechanics too play an equally significant role. Automatic trade orders (such as stop losses) at particular levels can create floors and ceilings for stock prices -- and frankly, so can the increasing popularity of technical analysis. As scores of new traders pick up technicals, the practice can become a self-fulfilling prophecy.

With all of that in mind, here's a look at a few different kinds of support levels worth watching for.

1. Horizontal Support

Horizontal support levels are price floors that are in place at a specific price level. Investor psychology and fundamentals are two of the most common ways to these support levels get formed. Take a look at Fannie Mae's  (FNMA) chart below. The stock had a horizontal support level at around 90 cents per share, and the company's stock price was been continually bouncing off of that level at the time the chart was captured.

 

That could be because investors believed that Fannie had a fundamental value such that buying below 90 cents per share made the stock too undervalued for investors to pass up. Or maybe a big investor had a buy operation that was building a position with a big limit order at or below 90 cents. Either way, the reasons for support don't matter to technical analysts; only the results do.

It all ultimately boils down to supply and demand for shares. That 90-cent level in FNMA is the spot where there's been an excess of demand for shares; in other words, it's a price at which buyers have been more eager to step in and buy shares at a lower price than sellers have been to sell. That big pocket of demand at 90 cents is significant, but it's important for traders to be reactionary. By actually waiting for a bounce off of support before buying, you're verifying that those buyers are still there before you put money on a trade.

On the other hand, a violation of support is a major signal that shares could be opening up to a lot more downside risk.

2. Trend Line Support

Support lines don't have to be horizontal, though. Another common form of support is trend line or trend channel support -- support that takes place along a trend line that's sloping. Take a look at the chart below to see an example.

In this chart, there's a clearly defined support and resistance level (in this case, they're parallel, so they’re known as a trading channel), but it's uptrending. The support line connects a series of higher lows on the chart. If you were a buyer of NovaGold  (NG), it would make sense to pick up shares of the stock when it was just starting to bounce off of support, since those levels get you filled at lower (and more profitable) share prices.

3. Moving Average Support

The moving average, essentially a line that represents a stock's average price over a trailing period of days, is a very important indicator on any technical chart. Commonly, moving averages act as support and resistance, acting as price floors and ceilings depending on which side of the moving average the stock's price level is on.

Take a look at how the 200-day and 50-day moving average acted as support for the S&P 500 in late 2009.

 

Again, the moving average bounces aren't magic here. Instead, moving averages can act as key support (or resistance) for the same reasons that the other two flavors of support do. Again, it all comes down to supply and demand for shares.

When you're looking at moving averages, it's important to remember that more days means a stronger support or resistance level. In other words, the 200-day moving average is a more reliable support level than the 50-day. Generally speaking, you want to focus on timeframes that have some relevance to a stock's price cycles -- in other words, periods that market participants are using to weigh their portfolios' performance. These are often preset in charting software.

The Value of Confirmation

Whether you're a burgeoning technical trader or an old-school fundamental investor, technicals can provide value for your portfolio by helping you get into positions at the best short-term levels.

With all the value that support can provide, it's important not to fall into the trap of believing that a stock will always obey its support levels. Markets are constantly changing, and that means that breakdowns and breakouts are inevitable. That's why it's often a good idea to wait for confirmation before taking a technical trade. In short, confirmation means that you wait for the technical pattern to be tested before you sink your money on the line. Often, abstaining from trading for a tick or two will come with a small opportunity cost but will significantly increase the number of successful trades you see.

Like nearly any element of investing, technicals require experience before you can expect to cash in on repeatable returns. So pull up some charts, and find some support.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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