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Support level

Support level is a key concept in Technical Analysis that is very helpful in determining the right moment to buy in an uptrend or to cover short positions in a downtrend.

Eric asks:

Eric was passing by John’s house and thought he’d pay him a visit.

Eric, the Beginner

Eric, the Beginner

Hi John, what’s up?
John, the Trader

John, the Trader

My computer’s just crashed. I guess I need to call technical support.
Eric, the Beginner

Eric, the Beginner

Maybe not. Let me take a look at it. By the way, speaking of support reminds me that I’ve stumbled on that term in the financial press before. What is it exactly?
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It is the price level at which the buying interest is strong enough to overcome selling pressure and push the price higher. Thus, support is visible on the chart in the form of bottoms – these take shape precisely because of the existence of support. Support usually refers to the previous low and that previous low is quite often assumed to be the future support level. A support line is a line that connects previous lows – it is an estimate of the future support levels. The chart below presents an example of a support line (charts courtesy of http://stockcharts.com/):

S&P 500 Support Level

The Psychology of Support

The formation of support levels is rooted in human psychology. To illustrate this notion let us divide the market into three groups of people: the buyers, the sellers, and the uncommitted. Let us further assume that after some time of price fluctuating around the support level, it starts to rise. The ones on the long side of the market are happy, yet regret not having bought more. Should an opportunity arise (i.e. should the price return to that support level) they could increase their commitment. The ones on the short side of the market realize they made the wrong decision and are hoping that the price will go down to the place where they entered the market so they could liquidate their positions. Finally, the uncommitted see that a new uptrend (be it short or long term one) has begun and are waiting for the next good opportunity to buy. So when the price finally drops their concerted effort is strong enough to push it upwards after reaching the support level.

Determining the Strength of a Support Level

The significance of a support level can be measured in three ways:

  1. Time spent in the support area – the greater it is, the more important that area becomes.
  2. Volume – the greater it is, the more significant the support level is. That is because heavy volume indicates bigger interest in that area and corresponds with more people participating.
  3. How recently the trading near the support level took place – the more recent the trading, the more significant the support level is. It is because people remember recent events more clearly and in a more vivid way and since the formation of support depends on people’s feelings and emotions this factor is quite important. 

Rising and falling support lines

So far, only horizontal (or nearly horizontal) support lines were considered. But once an uptrend has begun, it is often impossible for the price to fall down to the point where it begun to rise in the first place. And in a downtrend consecutive support levels are usually lower and lower. This is why trendlines (in uptrends) or channel lines (in downtrends) are often used as support lines.

An upper trendline is a line that connects (at least two) troughs in an uptrend. Once an upper trendline is established, it is treated as a support line. A chart below shows an example of an upper trendline acting as a support line:

Gold's Rising Support Line

A channel is an extension of the trendline technique. Sometimes price trend between two parallel lines, one of which is the trendline – these lines are said to form a channel. In a downtrend, a trendline is constructed by joining the successive peaks, hence the parallel channel line joins the consecutive troughs. And this line may serve as a support line in a downtrend. An example of a channel is presented below:

Down Channel Acting As Support For Gold

Retracement levels as support

Another way of finding future support lines in the market is the idea of retracement levels. This notion stems from the observation that after a move in the direction of the prevailing trend, the price tends to retrace some part of it. The breadth of this correcting move depends mostly upon the strength of the main trend. There are various popular sets of these retracement levels, two of which seem to be employed most often: 33%, 50%, 66% and 38.2%, 50%, 61.8%. The latter group is called Fibonacci retracement levels and seems to be slightly more accurate than the first one. An example of Fibonacci retracement levels can be seen on the chart below:

Fibonacci Retracement and Silver

The support levels obtained through the use of Fibonacci retracement levels proved accurate in the analysis of silver price movements.

Support line penetration and role reversal

If a support line is penetrated by a significant amount, it becomes a resistance line, i.e. a line off which the price is more likely to bounce than to cross it from below – it is a concept contrary to the one of support. The same psychological factors (such as grief and regret) as in the formation of support play an important role in this case. An example of a support line becoming a resistance line is shown below:

Support Line Becoming A Resistance Line for US Dollar

Verification of a breakout

In order to consider a violation of a support line valid, at least one of the criteria listed below should be met:

  1. The move below the support line should be significant. There is no clear rule telling what constitutes a significant move. Some use 3% as a benchmark in case of important support levels and 1 % in the short-term ones.
  2. It should be accompanied by high volume.
  3. Price should close below the support level for 3 constructive trading days to confirm the breakout .

Conclusion

The idea of support is a fundamental one in technical analysis. It can be very useful in making investment decisions as it allows a trader and an investor to predict certain market moves.

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