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Strategy IV: Support and Resistance

One of the most-common and best-known trading strategies is this: "Buy at the support level and sell at the resistance level." The significance of the support level can be understood this way: Imagine that on a given day, for some particular reason (or by sheer chance) a stock is traded very heavily at a certain price level. Also imagine that many traders remember this price level because they bought or sold the stock at this level. Next, suppose that the stock price first moves up away from this level and, later on, (for some reason or no reason) the stock price trades back again to the earlier level. Traders who previously bought the stock and sold it for a profit would likely buy it again at this level. Those who previously sold the stock at this level and missed the recent run-up would have a chance to buy it back. Such buying activities usually slow down the drop and may reverse the momentum. At least, the stock price may take a rest at this level before moving in a new direction. We can then say that the stock price has hit some "support level," by which we suppose that it most likely will not quickly drop through it. The sensible trading strategy is, of course, to buy the stock near this support level, monitor it closely, and sell it to cut losses if it falls meaningfully lower than the support level. If the support level does prevent the stock price from falling and it starts to bounce back, the trader can make a nice profit that is usually much larger (!) than the amount of loss incurred if the trade turned south and loss had to be cut.

Figure 7. In the previous 5 days MSFT has consistently bounced back every time after it touched 56.15. There is a good chance that 56.15 is a significant support level. The strategy is to buy the stock near 56.18 and hope to sell it at 59, when it is 3/4 of the way back to the previous peak at 60. As the buy order is confirmed, one should enter a stop loss order to sell the stock at 55.71, a meaningful break past the support level at 56.15.

"Resistance Level" is just the opposite. Here, the strategy is to short sell the stock near the resistance level, monitor it closely, and buy it to cut loss if it breaks meaningfully higher than the resistance level. If the resistance level indeed prevents the stock price from going up and it starts to bounce back down, the trader can make a nice (!) profit, usually much larger than the amount of loss he would incur if the trade turned against him (in which case, he would have to buy to cover).

Figure 8. In the previous 5 days IBM has consistently bounced back every time it touched 117.9. There's a good chance that 117.9 is a significant resistance level. The strategy is to short the stock near 117.88 and hope to buy it back at 113.5, when it's about 3/4 of the way back down to the previous trough at 112.5. As the short sell order is confirmed, one should enter a stop loss cover order to buy the stock at 118.45, a meaningful break through the resistance level at 117.9.