via ericwcharmon:
Authors note:
((This is the third or fourth writing in my ‘New Investor’ series of posts. I’ve received a lot of positive feedback from them and am excited people seem to be getting so much out of them! If you have anything specific you’d like me to cover, let me know! I also respond to all personal messages within a day or two!))
What Are Support and Resistance Lines, and How To Use Them For More Profitable Trading:
One of the toughest questions investors face (regardless of experience levels) is finding that magical entry and exit point in a trade that finds that magical balance of Risk vs Profitability. And while there’s no singular strategy that eliminates all risk and guarantees an investor an early retirement; there are tools of the trade that–if understood and properly utilized–act as complete game changes.
One of the most fundamental, beneficial, and immediately actionable tools that an investor can add to their arsenal is a firm understand of a position’s Support and Resistance lines.
For those of you reading who have been trading for awhile, you are probably already familiar and comfortable with this aspect of trading stocks and chart reading, so while this will mostly be aimed at investor’s new to the game, feel free to continue reading and think of this as a review.
So, What Are They?
The concept of support and resistance lines stems from technical analysis–which is one of the two primary methods of analyzing the stock market. Technical analysis lends itself to, in my opinion, the more measurable side of a position. Examining trends, past market data, along with volume and price.
Before branch off into specific definitions for both the support and the resistance, they can both be broadly defined as specific price points in a stock where it is most likely that the price will stop and reverse.
These price points are determined through pattern recognition. Specifically, recognizing at which points the stock in question will reach reach a point multiple times without moving passed either set point.
The Support Line
The Support Line (or level) is the price point at which a stock tends to find just that–its support. Both the support and the resistance lines are formed by volume. In the case of the support, this line is formed when a stock drops and reaches a low enough price point to entice a surge of new buyers–thus increasing the volume and price and preventing it from dropping any further. Once a stock finds its support–and due to the increased volume–the stock is more likely to ‘bounce’ off of the support level and begin moving upwards rather than breaking through that bottom price point.
Because the support acts as something of a safety-net for a position (although–less dependable) it’s always a good idea to have at least a rough idea of a prospective stock’s line of support before investing. This–obviously–gives you an idea of potential risk, but it’s also a great place to set your buy-in price. Knowing that the stock in question has a decent support line waiting for it at–or around– that price helps lessen the risk of buy-in, and also gives you some fairly assured room for growth and profit as it heads towards the resistance line.
Keep in mind, once a stock has actually broken through its support line (with the exception of some occasional minor dips) it has the potential to–and probably will–enter a state of free fall until it eventually finds an entirely new support level….could only be a few cents from the previous support—could hit rock bottom, so be cautious and set your Stop-Loss.
The Resistance Line
The Resistance Line is the support’s opposite. This is the point in an upward trend where profit-jumpers sell-off, resulting in a shift of volume and creating resistance and preventing any further upward movement above that point.
A stock that meets its Resistance Line will usually behave the exact same way it would if it touched its support; bouncing off of the ‘stock ceiling‘ that the has been created and begin moving downward towards the support level.
Just like with the Support Line, once a stock does manage to burst through its Resistance Level, it will continue pushing upward until finding a new Resistance Line–again, formed by the stock hitting a price where it’s share holders sell off large volumes to presumably secure profits.
What’s a Catalyst? What’s a Breakout?
A catalyst is a term that refers to anything that causes a surge, spike, or drop in a stock’s trend. Investors will usually try to plan their buy-ins–especially for more volatile stocks–around times or events that could act as a positive catalyst. These could be anything; press releases, earnings calls, conferences, product announcements–anything that could, hopefully, send a stock moving upward with enough momentum to break through any lines of resistance to maximize profits.
Technically, a Breakout can move the stock’s value in either direction. Upward if the catalyst is positive, and downward if negative. Unless you’re dealing with options or shorting though, you obviously want to see a positive catalyst.
A Positive Breakout, espically if you managed to buy in at a low cost–is an investor’s wetdream, regardless of whether you’re dealing with pennystocks or blue chips.
One thing that’s worth noting about the aftermath of a breakout, especially if you decided to hold your shares–or maybe even missed the peak of the surge–is that after a break out occurs, the generally, there is a direct coorolation between the previous Support and Resistance Lines and whatever levels will develop. The previous resistance line will now likely become the Support Level of the stock as it comes down from its breakout–rarely dropping much lower.
Counter to this, should a stock have a Negative Breakout, and spike downward, the the stock new reistance will probably be around the price point that once made up its support.
Hopefully this helped clarify some of the basic concepts of the Support and Resistance Lines. For those of you who didn’t already have a solid understanding of these principals, I hope you feel confident in now using them to turn some profits! And for those of you who already are well versed in the fundamentals (and stuck around anyway), I appreciate you taking the time to read! And again, if you have anything in particular you’d like as the subject of my next New Investor Friendly series, I’m always open to suggestions!
-Eric
Disclaimer: Consult your financial professional before making any investment decision.