ADVERTORIAL
Some price levels appear on a chart as a battleground between the buyers and sellers. We identify this from points of inflection on the trends. If you were to view this on a simple line chart, it would have the appearance of a "V" for the support level. This is the price where the sellers are stopped by the buyers and the downtrend reverses to an uptrend.
Market Memory
Many times traders like to know the "why" behind what we do in the markets. While not all technical indicators lend themselves well to answering the "why-does-it-work?" question, support is fairly intuitive. For example, if you use stochastic oscillators, you'd be hard-pressed to come up with a clear explanation of why it may work in certain market conditions. But with support, it makes good sense why the stock should, and often does, bounce off a support level. Think about what happens to create the support price. A stock price is in retreat, with the sellers creating new lows and the buyers stepping back to buy at lower levels. At some point, the buyers don't fall back but rather hold their ground. When the buyers stop buying at lower levels, the sellers begin to raise their selling price. The buyers then follow and the trend is reversed as the buyers create new highs. The next time the sellers drive the stock down, everyone remembers the price level where the buyers held their ground the last time. As the price approaches the previous support level, buyers become emboldened. At the same time, the sellers also remember the previous support and back off their selling as the support level is reached. This "market memory" reinforces the support level. Simply, everyone remembers where support was in the past and that influences their trading in the future. Thus, the support level tends to repeat itself for a time until it is broken or left behind for new highs.
Candlestick Charts
Candlestick charts help to identify support levels because the colors give the added dimension of telling us who is winning the day. Green candles indicate that the buyers controlled that day since a green candle is formed when the stock closes higher than it opens. Conversely, the red candle is formed when the stock closes at a lower price than it opened. Sellers win on the red candle day. Of course, any chart style may be used in finding support. As noted in the opening paragraph, the line chart clearly shows the "V" shape that reveals the trend reversal. However, the line chart only plots the closing price so the information related to open, high and low is lost. This information is captured by the bar chart, but given a choice between the bar and candle charts, the candle chart is our preference for the color coding.
"Best-Fit" Approach
Some traders have difficulty deciding where to draw the support line. Should you use the lowest point on the candle - the bottom of the lower "shadow"? Maybe you've heard that you should draw the line across the bottom of the candle body. Others will tell you that you should always use the closing price, regardless of the candle body color. We like to take the "best-fit" approach. Since this is NOT an exact science but rather a subjective assessment of the support line, we may use a combination of all three. What we're looking for is the level that "best-fits" a horizontal price level. Precision is not necessary and, in fact, is not realistically attainable. A great exercise is to scan through a series of charts and practice drawing your support line. You'll find that the best-fit approach will often be a combination of candle bodies along with the shadows. It is not common to draw a support line that fits exactly to only bodies or only shadows. One caveat is that if you fit the support line to the candle bodies but have many shadows extending through support, you must account for those shadows when setting your stop orders. For example, you may find your support level at $68 based on a line drawn along the bottom of the candle bodies. However, there are a number of instances where the shadows extend past the support to $64 or $65. In this case, you would need to set your sell stop protection below $64 since that is the range of trading.
Your goal with support is to pick a line which defines the expected range of trading. If the price drops below that expected range, you can assume that the trade has moved against you and you will exit your position. Support levels ultimately help you pick your sell stop protection price. So find support, drop below it a reasonable amount and be sure to exit if it reaches that level. Then assess your results and decide on any adjustments for the next trade.
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