In most of my articles I tend to focus upon current market action and draw the reader’s attention to a stock, commodity or other instrument which is likely to offer profits. In this latest offering, I’m going back to basics and some simple market geometry, the support line. Excerpts of this article are taken from the TradingKey manual, which has a full review of technical analysis and is an excellent companion to ProfitSource.
A support line can be said to symbolise a price at which sellers are no longer willing to sell. In other words, the support line will be found where the perceived ‘value’ of the underlying instrument is matched with its current market price. You can use integrated analysis to further explain (and predict) where future support lines may well show up - but that’s for another day!
If you consider it like this, you can see that the support level has the potential to interrupt or even reverse a down trend as investors and traders increasingly recognise that prices have fallen to a point where any further falls would begin to undervalue the asset. No one wants to sell something for less than it is worth!
When drawn, it is simply a horizontal line which connects several lows in the market: lows which the market has tested upon occasion and failed to break to the downside. The more times that the support line has ‘held’ the stronger it is and the more likely it will hold in the future. For a trader there is some instant gratification to be taken from a support line. It can become a great place under which to place your stop losses if you are already long a particular stock or asset.
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Likewise the support line can be an opportunity to start accumulating if the price is falling and your analysis suggests the support line will hold. Further to this, a price which is on its way down might look like a good ‘shorting’ opportunity, but if there are strong support levels coming up, the warning bells might start ringing as the stock may not go down much further or even bounce.
As with all technical analysis, the charts are ‘showing’ us the market forces at work through the movements in price, but it is often worth considering why a support line may or may not exist. This extra investigation may well go on to prove the additional piece in the puzzle when it comes to taking (or not taking) a trade. Are the fundamental components of the asset impacting the buy and sell prices for example? Hypothetically, it could be the point at which the company’s dividend yield (that’s the dividend paid to stock holders as an annualised percentage) is equal to the bank rate earned on savings. At lower prices, the returns from the stock investment exceed money placed in a savings account, so cash is better off in the stocks. If this is the case and dividends are halved or interest rates fall, there will be a natural knock-on effect to the status quo. Alternatively, a floor might exist to a stock’s price as it represents a level where a competitor has decided to acquire stock in a takeover bid or prices are being defended by a hedge fund to avoid a particularly large fluctuation following an option’s strike price being hit. Whatever the reason, the support line has plenty of applications.