"Buy low, sell high." You’ve heard this phrase a million times. It’s so wired into your brain, it seems easy to determine where a stock’s high and low points are. In reality, to find appropriate and consistent entries (lows) and exits (highs) might just be one of the hardest skills to master. The good news? There are different techniques you can use to find the potential entry/exit spots. One is to identify a stock’s support and resistance levels. It may sound easy, but it’s something Investools students need help with all the time and a reason they rely on our instructors to help them practice applying the concept.
How Low Can You Go?
Think of support and resistance levels respectively as floors and ceilings. A stock can drop until it falls to its natural floor and bounces. Prices can then rise until the stock reaches a natural ceiling and its progress halts. This all sounds good in theory. But bring up a chart to find these levels and you’ll be scratching your head. There are so many ups and downs, it gets hard to choose which one is the floor, and which one is just a step down the stairs, so to speak. This confusion is why figuring out a bullish position’s entry can be tough. How many times have you identified a stock that has “pulled back” and thought to yourself it’s the perfect time for the stock to bounce, only to see it continue a pullback?
It's All In Your Head
Support and resistance may sound like geeky technical terms for reading stock charts, but their existence is deeply rooted in investor psychology. Eventually a stock falls far enough so buyers are ready to overcome the stock’s sellers. It’s possible investors saw the stock previously bounce at these levels several times in the recent past. Or, maybe they noticed the stock had broken through those levels multiple times and then pulled back to those old highs. As more people see the same price levels, it attracts more interest. And, voila. Support is formed. It’s not magical, but simply a reflection of demand. This becomes a level where buyers overwhelmed the stock’s sellers. The opposite is true for resistance when sellers overwhelm the buyers. So, how can you identify these support and resistance levels?
The Power Of Two
One approach is to use multiple technical indicators together like, for example, the MACD histogram and the stochastic (see Figure 1). Stocks move up or down, but how far down is low enough to qualify as a support level? It could be when both indicators fall below their respective charts’ midpoints, and turn higher. Then, you look at the corresponding price level for the stock and see if it is at or above its prior low point. If so, you may have a new support level that can be used for a possible entry signal. As the stock rises and both indicators climb above their charts’ midpoints, new resistance levels may be formed, especially if it’s in an area where the stock has peaked before. These levels may also be used for exits.
Using two indicators together helps to smooth out random ups and downs and provide some consistency. You can use this kind of analysis on daily charts for intermediate trend trades with stocks, or on smaller time frames for short-term positions, like options trades.
It’s not about randomly identifying entries and exits for new positions. It’s about building a repeatable process using multiple technical indicators to identify common support and resistance levels. And keep in mind other approaches, including fundamental analysis, may assert very different views. Have other questions? Drop a line to firstname.lastname@example.org so we can answer them in the next Coach’s Corner column.