Stock Picks 101 - Support and Resistance

How good are you at profiting from the humble horizontal line in your trading? Sometimes the simple things get undervalued in favor of the more complex and intricate.

So, let’s take a look at how useful horizontal lines are on your stock charts. These lines come in two types: support and resistance. Support lines form when a price repeatedly moves down to a certain level and then bounces back up. Resistance lines form when a price moves up to a certain level and then bounces back down.

To find support and resistance lines (we’ll call them S/R lines for short) take a look at a daily chart. You’ll notice that for many stocks, the price will “respect” specific levels.

Support and resistance lines form around levels that market participants consider significant. The supply or demand may be pegged because of a great interest in a stock at a certain price in the past. Alternatively, a large fund may be trying to get in or out at a certain price over a long period of time.

Sometimes, if the S/R line starts to become too obvious, it may “blur” and become a support or resistance zone. Also, S/R levels may be breached briefly and then the price returns. This can be confusing if you’re looking for a breakout from an S/R zone.

It’s important to keep in mind that sometimes it’s necessary to use “reverse psychology” if an S/R line becomes too obvious. There are traders who “lie in wait” for a novice trader to play a breakout or breakdown that turns out NOT really to be a breakout or breakdown. Beware of the S/R “wolf” waiting to snag a naïve sheep at the S/R line!

Speaking of breakouts, S/R lines are meant to be broken. Going long after a resistance breakout and going short from a support breakdown are time honored trading strategies. This can significantly enhance the return of your best stock picks.

Another thing to notice on price charts is that past support can become future resistance and visa versa.

Finally, S/R lines can form in pairs. The price will bounce repeatedly between a support and resistance area. This creates price channels that can also be traded.

As you can see, being aware of support and resistance can give you insight into the future trading direction of a stock. Just be careful not to be too simpleminded.

Doug Newberry enjoys his position as host of the "Market Toolbox On Demand" online radio show and editor of the "Market Toolbox Newsletter." His company, Investing Systems Network, helps investors find the best stock picks by providing specialized investing tools and portfolio management software. It serves customers in more than 70 countries.