Episode 114: December 7, 2011
Stocks, Options & Warrants
by Andrew Horowitz
Sometimes, the easiest concepts are the most effective, and I wanted to discuss one of those simple yet powerful concepts in this episode of the Winning Investor.
I'm frequently asked how to locate a support level on a stock chart in order to find a better price to add a stock to the portfolio. For a bit of background, remember that we first start with fundamental or ratio analysis before adding a stock to our portfolio and then once we have a list of fundamentally strong stocks, we then look to the price chart of the stocks we're looking to buy.
Let's focus for the moment on what a support level, or bounce level is in a stock and how to find it.
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What is a Support Level?
A support level on a price chart is defined as the point (or level) at which price has reversed to the upside, stopping a decline. Investors look to prior support levels on a price chart to forecast a future reversal or bounce-up in the stock price.
There's good reasons to do this. Partly, it has to do with self-fulfilling prophecies. Investors and traders see a prior support area on a price chart and then they enter positions, or buy shares, when the current price trades at that expected support level and - like magic - the price reverses higher.
There's certainly more to it than that, of course, but to me, that's the easiest way to view a support level - it's a level that people accept as a turning point in the price of a stock based on its chart and thus collectively, investors create the support level by acting on it when price trades back to the same price it reversed in the past.
Let me be clear, when we're talking about support, we're not talking about a single swing low price in the past. A support level is a historical level where price has reversed at least twice, preferably more, which you can see clearly on any standard chart. Most traders and investors use weekly and daily charts to locate these prior support levels, though intraday traders can use intraday charts to find very short-term support levels...but as usual, we're focusing our attention on the bigger picture support levels.
How Support Levels Affect Stock Price
Let's now throw in a more sophisticated explanation on why a key level might be a support price, other than the basic "it's support because traders act on it" explanation.
Prices move because of supply and demand, and investors use a large variety of methods to find the right time to buy a stock. We've already discussed fundamental valuation, and believe it or not, fundamental valuation plays a role in a visual support level on a chart.
Why? Let's assume that analysts have crunched the numbers and determined that a company's stock is fairly valued at $50 per share.
Let's also assume that a large number of funds that are active in a certain stock see a decline to a certain level as being fundamentally undervalued, and thus they will rush in to begin buying shares at that price. In this example, let's say that the price where these funds decide to buy is $40 per share. So, each time the stock price falls near $40, many of these funds begin campaigns of buying the stock. This type of logic in aggregate helps explain why a support level might develop on a stock without any reference to the price chart at all.
As a rule, investors tend to be more interested in fundamental valuation while traders tend to be more focused on the charts, which include analyzing and trading off of visual price support levels on the chart.
How Winning Investors Use Support Levels
One of the most basic principles of technical analysis, or using charts to make buy and sell decisions, is the study of chart-based support and resistance levels and then managing risk from there.
As you might suspect, a resistance level can be visualized as an upper ceiling where investors have taken profits or sold shares in the past - they may see price as overvalued or expensive at higher prices above what they feel is “fair value” just as investors see a stock as undervalued and worth buying when it is under what they consider to be fair value according to fundamental analysis.
So, finding a support level can be just as easy as viewing a line chart on the weekly frame on your favorite charting program. Look for similarities in price reversals to the upside, or what we call "Bounce Points." If you can see that price continuously reverses up off a certain price - it doesn't have to be an exact number - then you've located a support level that may very well act as a bounce point in the future.
I find it helpful to draw a line to connect the lows of a stock. Keep in mind that support levels do not have to be perfectly horizontal - they can be rising trendlines over time that show an upward slope.
Finding support levels is important for adding positions to your portfolio. If you've decided to add a stock to your portfolio, the best time to add it is on a pullback to a support level, and the best way to find support is to view the price chart over a long enough time period to see where investors have stepped in to cause the stock to bounce.
You can also locate a stop-loss, which is an order to liquidate your position if the share price declines by a certain amount, just under a chart-based support level. Many traders do this and investors can benefit from this practice as well.
So the next time you are about to add a stock to your portfolio, take a moment to see if there are any obvious support levels on the chart and if so, consider waiting until the share price comes back to that visual support level. You can set up alerts to let you know when a price is trading close to a support level you see on a chart. Then buy shares as price trades near or bounces up off of the support level. It couldn't be easier!
And of course consider picking up a copy of my latest book The Winning Investor's Guide to Making Money in Any Market is available at Amazon and other fine booksellers and in print and digital versions too!