A longer discussion of this strategy is also available.
This strategy uses support lines to define an entry point for a stock trade. Provided you draw the support (or trend) line properly, you purchase a stock right after its price is supported for a third time.
To find a good candidate for this strategy, you look for stocks which have had nice upward trends in the past. But these stocks must also have recently made a new low – and signficantly so. What defines a significant new low? A good rule of thumb is that the stock has not seen prices this low in 52 weeks or more. But this can vary depending on overall market conditions.
Here's an example:
Imagine the current date is late January 2016. You've been looking for candidates for the 3-touch support strategy and you think you've found one. The stock is SYK and its chart is displayed below.
SYK stock chart with entry on 3rd touch of support line, and exit at break of support line.
Although not pictured, you confirm with historical price data that the lowest price on January 11 (roughly $87) is a significant new low. The last time SYK was in that price range was early November 2015 – well over 52 weeks previous.
A straight line can now be drawn from this price point through the more recent low on January 20 (roughly $88.50) and beyond. Extending the line past the second point is important, because it's now a waiting game: will future lows return to touch this line, or break below it?
If future lows break below the drawn line, it was not a true support line and the line must be redrawn. Again, you would draw this line starting from the lowest low on January 11 through the new low. Of course, if the new low is below $87, say $80, no line will be drawn just yet. You would need to wait for another higher low to establish a second point to this new lowest low of $80. That is not the case with this example.
But if a future low does return to just touch the trend line, the trend line is confirmed to be a support line. This is precisely what we have in this example. As you can see, on March 8 the price drops to touch the support line, then bounces away without penetrating it. Your next step is to place a buy order with your broker for the following trading day.
The exit condition for this strategy is simple. You immediately close out your position when prices breach the support line. In this example, this happens on April 29. Depending on where you caught it, your sell price would likely be around $108 versus your purchase price of $103. Not a bad gain.
Of course, it could be argued that profits could have been three times higher had we entered the trade when the trend line was first drawn. However, there are pros and cons to doing so, the least of which is that our strategy would need to be renamed the 2-touch support.
By the way, this strategy of using trend lines to signal when to enter/exit trades also works for stocks in price decline – only in reverse. For details, see the 3-Touch Resistance strategy.
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