Using Support Lines
(Third Time's a Charm)
Trend lines often act as support lines for prices. Provided the
trend line is properly
, you can see why it has this name. You expect the line
to 'support' the price. In other words, a support line exists when
traders won't let the price fall below it.
It is really quite amazing how many times prices will drop to
touch this line before resuming their climb upwards. Three, five,
seven touches or more is not uncommon within a short period of
time. Here are a few charts, all taken from the same time period,
that illustrate this fascinating phenomenon:
Multiple re-tests of
support line (stock: HLT)
re-tests of support line (stock: PX)
Multiple re-tests of
support line (stock: TSLA)
re-tests of support line (stock: VMC)
Support lines are an obvious advantage for the trader. Ideally,
you enter a position when prices first show signs of support, and
exit the position when they break that support level. But in
reality, this is difficult to do. Even if you suspect prices have
support, you can never be sure it will hold.
As a trader, the first thing to do is to draw a trend line. You
start at the lowest low and draw a line to the next price low.
Now, we all remember from high school geometry how it takes two
points to draw a straight line. But that line only becomes a
possible trend line when you can extend it, while maintaining the
same slope, such that another price low touches the line. If
prices subsequently bounce away from the line without penetrating
it, the support line is confirmed.
According to the 3-touch support
, you are to buy right after the third touch of
prices to the support line. Consider the following chart:
SYK stock chart
with entry on 3rd touch of support line, and exit at break of
The lowest low occurs on Jan. 11, from which a straight line can
be drawn extending past the low on Jan. 20. If this line is a
support line, we should expect that prices will return to touch,
or retest, this line. Once it does on Mar. 8, a buy order is
entered with your broker.
Many technical traders would criticize this strategy for being
overly cautious. They would say that to require a third touch
misses out on perfectly good trends that fail to meet the third
touch criteria. This is certainly true. Many legitimate trends
only have two touches before they end. Further, it can be argued
that two touches are even better than three or more. Why? Because
this means fewer traders feel the need to retest support and so
allow the stock to trend upward with an increasing slope.
Nevertheless, experience shows that you should place greater trust
in a trend line with three or more price touches. By acting on
just two, you are taking on more risk.
To reiterate, the 3-touch support strategy tells you to go long
just after the third touch of the support line, a touch being
defined here by the low of that day's prices.
As for exiting your position, the 3-touch strategy tells you to
sell when the daily price low falls below the support line. In the
SYK stock chart above, you would close out your position
immediately following the Apr. 29 support line breach.
With some financial instruments, including foreign exchange
(forex), you often see traders pushing prices past the support
line, only to immediately buy it back so that the day's closing
price remains above the support line. Here is where experience
comes in handy. If you lack this experience, however, you'll need
to observe what matters more for the instrument you are trading:
the low breaking the line, or the closing price. You'll also
discover that individual stocks not only behave differently from
one another. They also behave differently from themselves
depending on, say, what time of year it is.
Traders thus use support lines to identify an uptrend. Prices are
rising, and rising consistently. This provides confidence that the
purchase of this stock is returning a profit and may continue to
do so. Notice in all the charts above how on many days, the low
price touched the support line, but did not cross it.
The greater the number of these daily low touches (but not
crosses) of the support line, the more confidence the trader has
that this line is a valid description of the upward trend. These
tests of support encourage buyers to buy more after the price
passes the test. In economic terms, new rounds of buying
constitute demand for the stock. An accumulation of this stock
begins. On the supply side, those who already own the stock are
reluctant to sell it after support has passed these tests. Owners
now require a higher price to put their supply of stock on offer.
As already said, sometimes traders will test support by selling
down to the support line to see whether it will hold. If you just
recently bought above the support line, you now have cause to
worry. You'll ask yourself whether other holders of this stock
will defend their positions by rushing in to buy more. If and when
the support line does hold, those selling may become aggressive
buyers. Because this exercise just confirmed for them that buyers
outnumber sellers. This means that if you had just bought and
survived this test of support, you are more likely to experience a
Technically speaking, when prices penetrate the line to the
downside, support has been broken. The trend is over. However,
this may not be entirely true. Notice in the four charts grouped
above how three of the stocks (HLT, TSLA, and VMC) have broken the
support line, yet their prices continue to head up. But while this
may be true, it is important to understand how the existing trend
line is no longer reliable. The 'break' of support can very much
be read as some holders of the stock 'breaking rank' with other
holders to sell at progressively lower prices.
In trading parlance, what occurs is a breakout – a penetration of
the support line by a candlestick. As already implied, some
traders require that the close must break the line to qualify as a
breakout. But regardless of how it's defined, the word is usually
used to refer to a significant violation of the trend. Sometimes,
however, breakouts appear to quickly reverse themselves. Yet if a
genuine breakout has taken place, the trend has fundamentally
changed its nature, and this usually signals an impending change
of direction. So on the one hand, if a downside breakout of
support is immediately followed by a series of higher highs, it
may indicate that the bulls have gotten a second wind and are
repudiating the breakout. But on the other hand, such moves after
a downside breakout are uncommon, so it is safer to assume the
trend has reversed course.
There is, however, the phenomenon of the false breakout, whereby
prices extend beyond the support line for just a day, only to
obediently fall back in line. After the temporary breach, prices
continue to respect the support function of the line. What is
therefore 'false' about a false breakout is only the conclusion
traders draw from it, because prices really do break the line.
One way to gauge whether a breakout might be false or not is to
consider the closing price on the day just before the breakout. In
an uptrend, if the close is at or near the high for that day, odds
are good that it's a false breakout. This is because the breakout
was likely due to profit-taking that got carried away, or was
triggered by a rumor, or was just due to some random event. But if
the closing price on the preceding day is at or near its low price
for the day, chances are the breakout is real.
In the end, if the support line is confirmed to be broken, make
sure you discard it as a trading tool. But then again, you may
want to leave it on the chart if you plan on trading the same
stock as it swings back downward. Often times, old support becomes
and vice versa.
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