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Knowing the lowest price a financial asset has reached over a sustained time can be useful. In trading, a low point can be described as a support level. It won’t necessarily tell you exactly when the right time to buy or sell is. However, when you combine it with technical indicators and market data, it can be a useful way to determine an asset’s current status.
This guide will define support levels in trading and explain how to use this information to make better decisions.
Support, in general terms, is the price an asset doesn’t go below. You can think of support as the floor. The value of an asset will rise and fall, but it doesn’t go lower than the support level. This support level definition comes with some caveats.
The first caveat is that identifying a support level requires time and analysis. You can’t look at a price chart and use a random low point as the support level. The point at which the price stops falling and rebounds need to be hit multiple times to be deemed a support level. So, the price must go close to the floor, but never beyond it, multiple times for a support level to be validated.
The second caveat is that support levels aren’t fixed forever. They establish themselves over a certain period and, as a result, you need some data to confirm a price point has become a support level. However, sometimes the price of an asset will go beyond the support. This is known as a breakout or a breakthrough.
If the breakout is short-lived, the old support level might remain intact. For example, if the support was $1 and dipped to $0.90 for five minutes but didn’t reach that low again, we could say $1 is still the support level. However, if the price continues to hit or go close to $0.90, that would be the new support level.
This means you have to be fluid in your understanding and assessment of support levels. They are used to find the floor, aka the lowest price, an asset reaches before rebounding. But sometimes the price breaks through this proverbial floor and a new low is established. Therefore, support levels are fixed, but they’re not fixed indefinitely.
A support level for Amazon stock could look something like this:
Price High: $100
Price Low: $90
Price Average: $95
Price High: $110
Price Low: $93
Price Average: $101.50
Price High: $105
Price Low: $91
Price Average: $98
In this example, the daily high moves around quite a bit. In contrast, the daily lows are all close to $90. Specifically, the price never drops below $90. Therefore, on a very basic level, we can say $90 is the support level in this example.
Support levels tell us the lowest price an asset will reach before rebounding. Again, this comes with a caveat. Support levels can be seen as theoretical low points. It’s a recurring low point, according to price analysis. However, there’s nothing to say the price won’t go below the support level. Trading is unpredictable.
No one knows for certain how the markets will move. That’s why trading carries a certain amount of risk. It’s also why you can’t guarantee that a support level won’t be breached. However, using support levels is an attempt to bring some certainty to an uncertain situation. That’s the goal of technical analysis and any other type of analysis you do as a trader.
So, you can use support levels to see the lowest price point for a financial asset based on evidence obtained over an extended time. You can use this information in three main ways:
You can use support levels to find when it might be wise to enter a trade. For example, if the current price of an asset is close to its support level but your analysis suggests buying activity is increasing, it could be a good time to open a long position.
You can use support levels to set stop-loss limits. Although stop-loss limits should be based on your own financial tolerances, support levels can also be used as a guide. If you know $50 is an established support level, you can set a stop-loss just below it.
The thinking here is that the market should naturally rebound once it approaches $50, which makes it a natural stop-loss point. However, if the price happens to drop below the support level, you’ve got your safety net (i.e. stop-loss) to limit any unexpected losses.
You can use support levels to get a general overview of the market. If the price of an asset is constantly trading a lot higher than the support level, that’s a sign the market is strong. If the price is hovering around the support level, it means the market is weak and a breakthrough could happen.
It’s almost impossible to talk about support levels and not define resistance. We won’t go too far into the specifics of resistance levels in trading, but it’s worth comparing the two:
You can see support and resistance as two price extremes: the low and the high. The support is the floor, the resistance is the ceiling.
There are three main ways to find a support level. Some strategies are more advanced than others. The simplest but most prone to error is the round number theory, while the most advanced strategy is technical analysis:
This is less of a strategy and more of a theory regarding support levels. The idea is that prices tend to stick at round numbers such as $100. There are two reasons for this. First, inexperienced traders tend to buy or sell on whole numbers because it feels more intuitive. So, it somehow feels right to see it at $100 rather than $100.02.
The second reason whole or round numbers can become support levels is due to institutional traders. It’s often the case that large investors use round numbers as stop orders. So, they tend to set buy or sell orders at a round number. Because they’re trading large amounts, this can impact the market and define a support level.
Plotting trendlines on a price chart can help you establish support levels. The aim here is to connect the dots between daily low points. Once you can draw a line through these points, that’s the support level.
This is where you carry out technical analysis using price data to determine the moving average. The line created by moving average data will often be smooth, i.e. you get a straight line that develops over time. The moving average line can find a support level because it doesn’t fluctuate like individual price points.
Basically, you’re looking at the average price over time to determine what the low point is. You can also use other technical indicators to determine what the support level is. One indicator that’s often used is Fibonacci retracement.
The main reason to establish and use support levels in trading is so you have an anchor point. If you know the lowest price an asset has achieved and rebounded from, you can make decisions based on that. If the price is significantly higher than the support level, the market is likely to be strong and vice versa.
The downside to using support levels is that they’re just a concept. They aren’t technical indicators. A support line isn’t fixed and there’s nothing to say the price won’t go below it. This means you should use support levels with a sense of caution. Don’t see them as the ultimate line. Use them as a guide. Experienced traders often prefer to use support bands rather than lines.
This gives you a price range rather than a single point. This can often be a better way to think about support because it allows for fluctuations. That doesn’t mean support bands are any less of a concept. Prices can fall below the lowest point in a range. However, it can be a useful way of determining the proverbial floor price of an asset.
Thinking about support levels in this way can help you make better decisions when you’re trading stocks, forex, commodities and any other financial instrument. There aren’t any guarantees you’ll make a profit by using support data. But, if you combine support levels with other types of market data, you’ll give yourself a better chance of making the right moves.
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