By Jonas Elmerraji
Posted on June 7, 2010

There are few investing topics as controversial as technical analysis. Dismissed by some as “tea leaf reading” and paraded by others as a technique with incredible profit potential, technical analysis has its fair share of both fans and opponents. For those looking to add fuel to their portfolios with this increasingly popular system, it's important to understand how technical analysis works.

Simply put, technical analysis is the practice of examining stock charts to determine a stock’s future price movements. Since technicals burst on the Wall Street scene in the 1980s (after being developed for commodities merchants in Europe and Japan in the 17th and 18th centuries), they’ve been one of the most difficult topics for traditionally trained financial professionals to grasp. After all, the idea that you can simply look at a stock chart to predict the future comes at odds with the fundamentals-based investing models that classical economists devoted their lives to.

But many of us have come to terms with the impact of technicals on the market today, because technical analysis is less about mystically predicting the future than it is about developing trading expectations based on investor psychology and trading mechanics.

Some of Wall Street’s most successful hedge fund managers use technicals either exclusively or in conjunction with their fundamental stock analysis. And the top tier of small-time traders can often produce successful trades as much as 90% of the time. That factor alone makes technicals worth paying attention to.

Today, let's take an in-depth look at trend line support, one of the keystones of technical analysis, and explore how it can help you bank extra trading profits.

Support, one of the biggest concepts in technical analysis, essentially is an area that a stock’s share price has difficulty moving below -- a sort of price floor (the opposite of support is known as resistance). Support is significant because it provides traders with insight on when to pull the trigger on a trade as well as how to minimize downside risk.

Since stocks are at a short-term low when they reach their support levels, buying stocks at support provides an investor with lower entry prices and potentially higher profits. And since support is a sort of “price floor” for a stock, placing stop losses right below support helps mitigate risk when a stock makes a high-percentage fall through that floor (something known as a breakdown).

Support levels rarely appear at arbitrary prices. Instead, investor psychology and trading mechanics tend to drive this impressive chart phenomenon.

With investor psychology, for example, support levels can happen frequently at price levels where high-volume buying took place. That’s because when a stock slides down to a price that many investors bought at, investors who felt that those levels were attractive prices originally will often re-up their positions en masse, adding bullish pressure to the stock’s price and halting the slide at a technical support level.

Psychology can impact a stock at seemingly random price levels too. When the S&P 500 falls down to a major round number like 1,000, investors often cool their selling pressure.

Trading mechanics play an equally significant role. Automatic trade orders (such as stop losses) at particular levels can create floors and ceilings for stock prices, as can the increasing popularity of technical analysis. As scores of new traders pick up technicals, the practice can become a self-fulfilling prophecy.

With that explanation of technicals in mind, here’s a look at a few different kinds of support levels worth watching for.

1. Horizontal Support

Horizontal support levels are price floors that are in place at a specific price level. Investor psychology and fundamentals are two of the most common ways that these support levels get formed. Take a look at Fannie Mae’s (FNM) chart below. The stock has a horizontal support level at around 90 cents per share, and the company’s stock price has been continually bouncing off of that level since November.

That could be because major investors bought shares at 90 cents and buyers continue to come out at that level, pushing shares higher with their buying and taking the profit incentives out of selling. Or it could be that Fannie has a fundamental valuation such that buying below 90 cents per share makes the stock too undervalued for investors to pass up. Either way, the reasons for support don’t matter to technical analysts -- only the results do.

In Fannie’s case here, buying near support makes sense in hopes of a bounce back up.

2. Trend Line Support

Another common form of support is trend line or trend channel support -- support that takes place along a trend line that’s anything other than horizontal. Take a look at the chart below to see an example:

In this chart, there’s a clearly defined support and resistance level (in this case, they’re parallel, so they’re known as a trading channel), but it’s uptrending. If you were a buyer of NovaGold (NG), it’d make sense to pick up shares of the stock when it was right around support, since those levels get you filled at lower (and more profitable) share prices.

3. Moving Average Support

The moving average, essentially a line that represents a stock’s average price over a trailing period of days, is a very important indicator on any technical chart. Commonly, moving averages act as support and resistance, acting as price floors and ceilings depending on which side of the moving average the stock’s price level is on. Take a look at how the 200-day and 50-day moving average acted as support for the S&P 500 in late 2009:

When it comes to moving averages, it’s important to remember that more days means a stronger support or resistance level. In other words, the 200-day moving average is a more reliable support level than the 50-day.

The Value of Confirmation

Whether you’re a burgeoning technical trader or an old-school fundamental investor, technicals can provide value for your portfolio by helping you get into positions at the best short-term levels.

With all the value that support can provide, it’s important not to fall into the trap of believing that a stock will always obey its support levels. Breakdowns and breakouts are inevitable, which is why you always need to wait for confirmation before taking a technical trade. In short, confirmation means that you wait for the technical pattern to be tested before you sink your money on the line. Often, abstaining from trading for a tick or two will significantly increase the number of successful trades you see.

Like nearly any element of investing, technicals require experience before you can expect to cash in on repeatable returns. In the meantime, you can hone your technical skills by keeping on top of the weekly analysis on Stockpickr.

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