Apr 21, 2014
Written by:
Al Hill
Buying a stock or security at support is a tried and tested strategy that has proven to work successfully over the years. This principle is based on the basic laws of supply and demand.
To put it simply, buying at support is the process of identifying when the longs or bulls are perceived to have the upper hand at a specific price point after a weak pullback into a clear support zone.
Not too simple uh?
Now that I have made myself feel super smart, I will spend more time throughout this article assisting you in basics of how to identify support so you can learn to pull the trigger when the opportunity presents itself.
At the end of this article you will know how to:
To buy a stock you need to know a few things.
Below is an example of what a buy order for 1,000 shares of Microsoft would look like in the Tradingsim Platform.
It’s really funny when you think about how such a simple action has such great financial implications. Amazing what you can accomplish in just a few short clicks of a mouse over the Internet.
There are a multitude of reasons you want to buy a stock at support, but I only need two to drive the message home.
Trading has very little to do with being right, it’s being right at the right time while also limiting the amount of capital at risk. By entering a trade at support, you have allowed the market to pullback to a significant level which lowers your risk in two forms: (1) you are buying after a decline so you have already avoided the first wave of selling and (2) you are entering a position at a previous support level which increases the likelihood the stock will hold under pressure.
I know you may be thinking, well no expletive Sherlock, I of course need to settle on a price before buying the stock. While this is true and doesn’t sound like rocket science, how you buy stocks must be a repeatable process where you can enter and exit positions without hesitation. This mental skill is developed over time as you begin to build confidence in yourself and your trading system of choice.
Learning to consistently buy stocks at support will get you in the habit of being patient and waiting for the market to come to you. It also provides you a clear method for entering trades before you branch out into the endless options that exist to analyze the markets.
There are a number of charting methods; however, the easiest way to identify support levels is to use point and figure charts. I am not going to go into the details of point and figure charts for this article, but basically it is the plotting of x’s and o’s which represent the price movement of a security independent of time. As you look at these charts, the support levels will pop out at you as the congestion zones are super clear.
Below is a point and figure chart of the stock MSFT. Notice how the stock bounced off support in the $450 region and then make a move up to $570. It’s really easy to see the support zone due to the congestion of x’s and o’s.
In lieu of a point and figure chart, you can use candlesticks to see where candles are bunched together or big swing points that have served as bounce zones in previous chart action. We will cover a few of these examples of where to buy at support later in this article.
One of the greatest challenges new traders face is knowing when they are wrong in a trade. No matter how clear or strong a previous support zone may have appeared, at the end of the day, you have no idea if the support zone will hold or not. I have seen stocks turn on key levels to the penny, while in other cases the market rips to the downside through these levels as if they never existed.
This is why I am a firm believer that there is no value in getting hung up on finding the exact entry point or beating yourself up if things don’t go exactly as planned after entering a trade. At the end of the day, trading is a game of edges.
You know you are wrong once the stock pushes well beyond your identified support zone. I can anticipate your question of, “well what is well beyond the support zone?” The answer to this question will be dependent on the time frame (i.e. 1min, 5min, daily), but a general rule of thumb is that you should not exceed the support level with high volume and a price break which invalidates the pattern.
For swing traders this will be a break of 10% or more depending on the volatility of the issue and for day traders 2%-3%, again depending on the volatility of the security this rules of thumb can be greater or less. Once this level of breach has occurred, you need to immediately jump into managing the trade and actively look to limit your losses by exiting the trade after a bounce in your favor.
After you have had a significant breach as previously stated, your so-called friend “support” should now be looked upon as the villain of resistance. The premise here is that the longs put up their best fight, but were unable to “hold the line”. When this occurs there is a contingent of traders that do not place stops in the market (myself included). These traders will see the price break and now move their limit orders to exit the position at the previous support area.
You may be asking yourself, why? Well, most traders have the need to get out even. We can argue all day around why this is the case (ego, since of getting even with the market, etc.), but the point is we can use this bit of human psychology to our advantage. If we know there are a number of longs that are dying to get out because they were burned, common sense tells us that these traders will likely look to exit their position at their entry point, a.k.a. the support area.
This now means that the area which was previously support becomes stiff resistance to any bullish counter rally.
Not a believer? Check out the below chart and see for yourself how Angie’s List failed to get through previous support. From the action in the chart, you can see the longs were dying to get out even.
I don’t care how great you think you are or how easy trading the markets are to you. You will end up losing if you attempt to buy stocks at support when the stock is going through a sell cycle or bear market.
So, to make this general point clear of when to not buy pullbacks, read the below guidelines:
The more of the above 4 points that are true, the harder it will be for you to make money buying at support.
Take the above examples of when not to buy at support and flip them on their head. Again, you can make money buying or selling stocks at any point, but it’s how easy you want your money making experience to be.
I consider myself a visual learner so for me there is nothing like reviewing a chart. In the next two examples, we will cover buying at support. I am going to cover two real-life examples so you can get a feel for what you should be looking for.
The above example is a trade I recently made which was a purchase of CNQR in the $95 dollar range as this was major horizontal support going back the ~5 months. Notice how CNQR had a nice base there before rallying up over $130.
After I entered the trade, the market proceeded lower during the “spring pullback of 2014” (by the way, I just made that up, pretty catchy). While the March/April 2014 pullback was not like ’87 or ’00, it still had some bite in her.
So, the question for me now is will CNQR rally from here or am I truly stuck in a losing position?
For you reading this article, the question is really irrelevant, the bottom-line is that you want to identify stocks that are approaching historical support levels and doing so on light volume. This implies that the selling is overdone and a rally is likely to occur.
Buying pullbacks in an uptrend is by far my favorite method for buying a stock at support. While buying horizontal support zones can be profitable, there is nothing like buying a pullback where the low point is always higher than the previous low point. In my opinion this increases the likelihood that you will end up on the right side of the trade.
The next chart I did not trade, but I wanted to call out a stock that has been hot as of late – Tesla (TSLA).
TSLA has had one of those runs that even a 3-year old could have turned a profit in 2013. An example of buying the pullback in an uptrend can be seen in the fall of 2o13. After a nice run up, TSLA began to settle into a groove of making higher highs and higher lows without much selling pressure. As you can see from the charting example, if you would have placed your buy order at the support line in September, you easily could have ripped down 15%.
Again folks, this is not rocket science. You want to identify clear areas of support and use those to your advantage.
You can use a host of complicated systems (Elliott Wave, Point and Figure counting) or oscillators to determine when to exit a trade. The reality of it is while these all work quite effectively, a basic rule of thumb is to look back at the last 3 price swings. If the average swing was 20%, then odds are you are likely to make 20% on your position before a counter rally ensues. Now this again is a very basic approach to ball parking profit potential, but until you are ready to take on more complicated methods, this guiding principle will keep you on the right side of the trade.
I personally buy at support for my swing trading strategy. It’s boring, predictable and also highly profitable.
Only you can determine if this strategy is right for you and your personality. There are some of you that will gravitate towards the breakout trade, because you want the immediate action since the stock is crossing a clear decision point. Others will have the same sentiments as I and will look for the support zone as the right time to buy.
At the end of the day, whatever you do just needs to make money on a consistent basis.
If you are looking to practice trading pullbacks, please take a minute to test drive our trading simulator to get a handle on the markets before investing your hard earned money.
Good luck trading!
– Al
Tags: Basics of Stock Trading
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