Support Levels Going to Support or… Break!
The stock price will either bounce off the support level or break it! Who knows for sure what kind of candlestick will be formed the next day or week? Every day, traders keep scanning the financial markets for entry points at support levels to trade long. The more a support level has been verified in the past, the more important the level. However the support level is not meant to support a decline forever. At some point, the level will give way and the stock price will head south, driving long positions into the red zone. The real question is whether the traders will honor their stop losses, or they will get trapped in a huge downtrend hoping for a retracement to the support level.
My dad usually congratulates me for predicting either an uptrend or a downtrend. “The stock price will head north, but beware the support level may not hold, so the price drops” is what I most often say. Most readers will think that I consider myself a winner in either case. That is far from the truth. The sentence above implies that I predict mostly an uptrend, but I could be wrong and I urge traders following my advice to trade out early. What does mostly really mean? Depending on the profit target and stop loss I set, a probability percentage favors long positions. Let me give you an example.
DV stock is currently trading at $40-45 range in the past 4 weeks and the support level at $40 is profound. It is the third time in the weekly graph DV stock has found support during the last 2 years. It seems to me that price will enter an uptrend soon and believe it’s now a good entry point to go long DV stock. Assuming I buy DV shares for $42 per share and setting a stop loss at $38, I stand to lose $4 per share. Risk has been calculated. I am planning to exit my position at $48, meaning I’m going for $6 per share profit. In order this trade to be profitable, I need to predict correctly more than 40% of the time. So, I suggest the support level holds, but there is still 60% chance that it’s actually going to break! In fact a support level breakout is much more likely to happen! The reward-ratio (1.5-1) though allows me to trade profitably, assuming the support level holds more often than 4 out of 10 times.
So, does the support level going to be broken or provide the necessary support? I honestly don’t know. If I was some kind of a magician and knew that support level will 100% hold, I should advise traders to buy as many shares as possible! It would be a sure trade, no need to set a stop loss; stock price will certainly not go any lower than $40 and you will make money by trading out at a higher price. Why bother setting a stop loss?!
Stock trading as any other form of gambling is based on mathematics and statistics. If a trader believes that a support level will not break 100%, he MUST risk his whole capital. It is like as if he knows a coin flip will end up head; no matter the odds he is given, he must bet on head! Of course, that is not the case and there is always a probability for the breakout and another probability for the support. By calculating them you are going to trust technical analysis and gain confidence. And truthfully, you need confidence if you need to be a profitable trader.