Lines of Support and Resistance
Stockscores.com Perspectives for the week ending March 1, 2008
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In this week's issue:
Support and resistance are two of the most basic concepts in technical analysis and yet they are often misjudged or misused by traders. Understanding what these straight lines drawn on a chart are based on is essential to reading chart patterns, and making money.
Resistance is a ceiling price that has held up for some amount of time, support a floor price. The idea is that these price ceilings and floors will hold up when the market price moves back toward them. Breaks through the ceilings and floors may indicate that investors have found new information to justify moving through these price levels. As a result, many trading strategies will work off of support and resistance.
Let's first learn how to establish support and resistance. These lines can be drawn in two ways. First, we can draw support and resistance as horizontal lines at price extremes which I call inflection points. An inflection point high occurs where the stock stops going up and starts going down. An inflection point low is the opposite, occurring where a stock stops going down and starts going up.
There can be minor and major inflection points and thus, minor and major support and resistance lines. The importance of these lines is dependant upon how far back the inflection points hold up as the highs or lows. Suppose that the high 7 days ago represents the highest point in the last 7 days, that means the stock has been going lower since and the high 7 days ago was an inflection point. The next important thing to determine is how far back in time can we go before we get to a higher inflection point? If the previous higher inflection point was only a week before, then the recent inflection point is a minor one and the resistance at that inflection point is also minor.
So, when considering the resistance at a recent inflection point, its importance is based on how long it has been since a higher inflection point. The same can be said for support, with the time since a lower inflection point serving as the arbiter of importance.
A stock that recently made a 52 week high has defined more important resistance than a stock making a 10 day high.
We can add to the significance of support and resistance with a little bit of artistry. When looking at the stock chart and drawing a line across the inflection point highs, we should also pay attention to how many times the stock has previously hit that price ceiling, or come near to it. This is where the artistry comes in, drawing support and resistance across multiple inflection points is not a science; we have to approximate a horizontal line that best fits the previous inflection point highs.
What do horizontal lines of support and resistance represent? Since it is the point where the stock either stopped going down and starting going up or stopped going up and started going down, it is really the point where the control of the market shifted from one group to another. Inflection point highs occur where the buyers lose control to the sellers and support demonstrates where the buyers took control from the sellers.
Resistance represents the maximum amount that buyers were willing to pay for the underlying company's fundamentals and support the minimum amount that sellers were willing to accept for the stock and its business.
The second type of support or resistance is drawn as either an upward sloping line across the rising inflection point bottoms or as a downward sloping line across the falling inflection point tops. These lines are often called trend lines and, different from horizontal lines of support and resistance, they demonstrate the prevailing mood among investors.
For example, a line drawn across a number of falling tops represents a downward trend line and really is an indication that investors are predominantly pessimistic about the company. Over time, the buyers are not able to show enough strength to break the cycle of falling tops and the sellers' control of the market.
How can we trade off support and resistance in its various forms? There are a number of potential trading strategies:
1. Anticipate changes in control at support and resistance - when stocks are trending up in to resistance or down in to support, they will often bounce, particularly at long standing and important inflection points.
2. Trade breakouts through support or resistance - when stocks trade sideways and clearly establish areas of support and resistance, eventual breaks through these price thresholds often lead in to trends.
3. Pull backs to trend lines - when the short term trend pulls back to the longer term trend line, the market often reverses in favor of the longer term trend.
4. Breaks of the trend line - the breaking of the long standing trend line is often the first step in a trend reversal.
The StockSchool teaches strategies in each of these areas for day, swing and position traders and the Stockscores Market Scan tool has present settings to search for stocks that may meet the criteria of these strategies.
You can build very simple trading strategies from these support and resistance concepts that can ultimately be very successful. The great majority of my best trading ideas have been descendant from one of the four set ups listed above.
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Rather than pick some new stocks this week, I thought it would be more educational to share an example of each of the four support/resistance set ups described above.Back To Top
1. XOM
XOM fit the criteria of Strategy 1 around the third week of January when it pulled back to long term, horizontal support at $80. Because it was showing volatility to the downside as it approached support, there was a good chance that sellers would get exhausted and the stock would bounce. This opportunity was discussed in the newsletter around that time.
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2. V.APH
V.APH was a stock that I featured in the daily newsletter late in October when it was breaking out from a sideways consolidation pattern, the basis for Strategy 2. At the time, the stock was around $0.27 but that break from a predictive chart pattern has evolved in to nice move where the stock is now at $1.25.
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3. T.POT
T.POT fit Strategy 3 during the third week of January when it pulled back to the upward trend line. That brought a good bounce that has taken the stock back to new highs since.
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4. GOOG
For Strategy 4, I prefer short selling stocks that are breaking their long term upward trend line with an abnormal move to the downside. That is what GOOG early in November and then confirmed in mid December when I discussed it in this newsletter. This breakdown began the downward trend that has taken the stock down quite dramatically lately.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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