Support levels are a technical analysis concept used by stock traders to find potential entry and exit points, as well as provide analytical insight for current trades. To do this, the first step is to understand what support is, how support is established, and then what your options are when the price reaches support. The final step is to incorporate support levels into a strategy, potentially using some other technical analysis concepts in conjunction, so trading decisions can be made based on the information.
What Is Support?
Support is an area where the price has bounced off of prior, or a price area where buyers step in to “support” the stock. This could be at exactly the same price, or may be at slightly different prices, forming a support zone. For example, if the price is moving mostly sideways, and the declines stop falling and bounce higher between $10 and $9.80, there isn’t just one price offering support, rather the whole $0.20 zone provides support.
This zone is marked by drawing horizontal lines on the chart for future reference.
Once we have drawn these lines, the price may “hold/respect” the support zone and bounce off of it, as shown in Figure 1.
The price could also “break” support by dropping through the support zone, showing that the buyers in that area have been overpowered by the sellers. This is shown in Figure 2.
Using Support Levels to Trade
Since support will either hold or be broken there are two approaches to trading off support levels.
1. Buy near support, once the price has reached the support zone and then is beginning to bounce back off of it. This indicates that the support zone has held and the price could continue to advance. A stop loss is placed below the support zone.
If you already own a stock, ideally the stock will stay above the support levels that it establishes. If it does, it is highly likely you can get a better sell price once the stock bounces off the support level.
In Figure 3 the price bounces off the same area of a prior low. Entries are taken when the price pops above the price bars that touched the zone. For the first two potential trades (blue circles) a stop is placed below the recent low, since that is support at that time.
On the third trade the price drops briefly below the support zone (expanding it), but then quickly rallies, presenting another buy opportunity. A stop is below this recent low since that is now the low of the support zone.
2. Price may also break support, in which case, it gives a signal to sell or take a short position. Many traders sell long positions when the price breaks support. Short positions are also taken when a price breaks support; this is called a “breakout trade.” This can be lucrative, but also risky, since false breakouts (see third trade on Figure 3) are common.
Another option is to let the price breakout, and then take a short position when the price moves back to the old support zone, and then begins to decline again. This is called a “second chance entry.” Stops are placed just above a recent swing high (in price) in either case.
It is prudent to add a small buffer to the bottom of the current support zone. Only sell or short if the price moves past the zone and your buffer. This gives the price a bit of extra room, helping to differentiate between false breakouts and legitimate breakouts where the price is likely to keep dropping. The size of the buffer will generally be bigger for higher priced and volatile stocks, and smaller for low volatility and low priced stocks.
Considerations When Using Support
Support often appears easy to trade in hindsight, but in real-time can be difficult. In advance we don’t know if support will hold or break. This is why it pays to actually let the price bounce off the level before initiating a long position; this provides some confirmation that support has held, and price won’t just keep dropping through the zone (although it may eventually).
Once a support zone is drawn, the price also may not move back to the area again; meaning that the trader is waiting for a trade that doesn’t arrive.
Price breaks support a lot, but often only marginally—called a false breakout—and the move doesn’t cause the big sell-off many traders are expecting. This means that selling your long position at support may give you a very poor price if the price simply expands the support zone and then bounces again.
When short-selling on support breaks, false breakouts are a constant reality. One way to reduce this is to let the price actually break out, drop, and then look for a short entry if the price moves back toward the prior support zone and begins to drop again (second-chance entry). The price may not always pull back to the former support zone though, which means missing entries on stocks that drop quickly.
The Bottom Line
Support is a price level or zone where buyers have stepped in to support the stock and it has bounced off the level. Support is used for finding trading opportunities, such as buying on support bounces or selling/shorting when support breaks. It can also be used for analysis. If holding a long position, keep the position as long as it stays above newly formed support levels. When support is broken it may be time to get out. Support is not a crystal ball though; you don’t know in advance whether support will break or hold. Adding a bit of a buffer to the support zone, or waiting for strong bounces or breaks can help reduce the chance of getting tricked by frequent false breakouts.