Support And Resistance

SUPPORT AND RESISTANCE

In the previous discussion of trend, it was stated that prices move in a series of peaks and troughs, and that the direction of those peaks and troughs determined the trend of the market. Let's now give those peaks and troughs their appropriate names and, at the same time, introduce the concepts of support and resistance.

The troughs, or reaction lows, are called support. The term is self-explanatory and indicates that support is a level or area on the chart under the market where buying interest is sufficiently strong to overcome selling pressure. As a result, a decline is halt­ed and prices turn back up again. Usually a support level is iden­tified beforehand by a previous reaction low. In Figure 4.3a, points 2 and 4 represent support levels in an uptrend. (See Figures 4.3a and b.)

Resistance is the opposite of support and represents a price level or area over the market where selling pressure overcomes buy­ing pressure and a price advance is turned back. Usually a resistance

Figure 4.3a Shows rising support and resistance levels in uptrend. Points 2 and 4 are support levels which are usually previous reaction lows. Points 1 and 3 are resistance levels, usually marked by previous peaks.

Figure 4.3b Shows support and resistance in downtrend.

level is identified by a previous peak. In Figure 4.3a, points 1 and 3 are resistance levels. Figure 4.3a shows an uptrend. In an uptrend, the support and resistance levels show an ascending pat­tern. Figure 4.3b shows a downtrend with descending peaks and troughs. In the downtrend, points 1 and 3 are support levels under the market and points 2 and 4 are resistance levels over the market.

In an uptrend, the resistance levels represent pauses in that uptrend and are usually exceeded at some point. In a downtrend, support levels are not sufficient to stop the decline permanently, but are able to check it at least temporarily.

A solid grasp of the concepts of support and resistance is necessary for a full understanding of the concept of trend. For an uptrend to continue, each successive low (support level) must be higher than the one preceding it. Each rally high (resistance level) must be higher than the one before it. If the corrective dip in an uptrend comes all the way down to the previous low, it may be an early warning that the uptrend is ending or at least moving from an uptrend to a sideways trend. If the support level is violated, then a trend reversal from up to down is likely.

Each time a previous resistance peak is being tested, the uptrend is in an especially critical phase. Failure to exceed a pre­vious peak in an uptrend, or the ability of prices to bounce off the previous support low in a downtrend, is usually the first warning that the existing trend is changing. Chapters 5 and 6 on price pat­terns show how the testing of these support and resistance levels form pictures on the charts that suggest either a trend reversal in progress or merely a pause in the existing trend. But the basic building blocks on which those price patterns are based are sup­port and resistance levels.

Figures 4.4a-c are examples of a classic trend reversal. Notice, in Figure 4.4a, that at point 5 prices failed to exceed the previous peak (point 3) before turning down to violate the previ­ous low at point 4. This trend reversal could have been identified simply by watching the support and resistance levels. In our cov­erage of price patterns, this type of reversal pattern will be identi­fied as a double top.

How Support and Resistance Levels Reverse Their Roles

So far we've defined "support" as a previous low and "resistance" as a previous high. However, this is not always the case. This leads us to one of the more interesting and lesser known aspects of sup­port and resistance—their reversal of roles. Whenever a support or

Figure 4.4a Example of a trend reversal. The failure of prices at point 5 to exceed the previous peak at point 3 followed by a downside violation of the previous low at point 4 constitutes a downside trend reversal. This type of pattern is called a double top.

Figure 4.4b Example of a bottom reversal pattern. Usually the first sign of a bottom is the ability of prices at point 5 to hold above the previous low at point 3. The bottom is confirmed when the peak at 4 is overcome.

Figure 4.4c Example of a bottom reversal. During January 1998 prices retested the December support low and bounced off it, forming a second support level. The upside penetration of the middle resistance peak signaled a new uptrend.

resistance level is penetrated by a significant amount, they reverse their roles and become the opposite. In other words, a resistance level becomes a support level and support becomes resistance. To understand why this occurs, perhaps it would be helpful to dis­cuss some of the psychology behind the creation of support and resistance levels.

The Psychology of Support and Resistance

To illustrate, let's divide the market participants into three cate­gories—the longs, the shorts, and the uncommitted. The longs are those traders who have already purchased contracts; the shorts are those who have already committed themselves to the sell side; the uncommitted are those who have either gotten out of the market or remain undecided as to which side to enter.

Let's assume that a market starts to move higher from a support area where prices have been fluctuating for some time. The longs (those who bought near the support area) are delight­ed, but regret not having bought more. If the market would dip back near that support area again, they could add to their long positions. The shorts now realize (or strongly suspect) that they are on the wrong side of the market. (How far the market has moved away from that support area will greatly influence these decisions, but we'll come back to that point a bit later.) The shorts are hoping (and praying) for a dip back to that area where they went short so they can get out of the market where they got in (their break even point).

Those sitting on the sidelines can be divided into two groups—those who never had a position and those who, for one reason or another, liquidated previously held long posi­tions in the support area. The latter group are, of course, mad at themselves for liquidating their longs prematurely and are hoping for another chance to reinstate those longs near where they sold them.

The final group, the undecided, now realize that prices are going higher and resolve to enter the market on the long side on the next good buying opportunity. All four groups are resolved to "buy the next dip." They all have a "vested interest" in that support area under the market. Naturally, if prices do decline near that support, renewed buying by all four groups will materialize to push prices up.

The more trading that takes place in that support area, the more significant it becomes because more participants have a vested interest in that area. The amount of trading in a given sup­port or resistance area can be determined in three ways: the amount of time spent there, volume, and how recently the trad­ing took place.

The longer the period of time that prices trade in a support or resistance area, the more significant that area becomes. For example, if prices trade sideways for three weeks in a congestion area before moving higher, that support area would be more important than if only three days of trading had occurred.

Volume is another way to measure the significance of support and resistance. If a support level is formed on heavy volume, this would indicate that a large number of units changed hands, and would mark that support level as more important than if very lit­tle trading had taken place. Point and figure charts that measure the intraday trading activity are especially useful in identifying these price levels where most of the trading took place and, con­sequently, where support and resistance will be most likely to function.

A third way to determine the significance of a support or resis­tance area is how recently the trading took place. Because we are deal­ing with the reaction of traders to market movement and to posi­tions that they have already taken or failed to take, it stands to reason that the more recent the activity, the more potent it becomes.

Now let's turn the tables and imagine that, instead of mov­ing higher, prices move lower. In the previous example, because prices advanced, the combined reaction of the market partici­pants caused each downside reaction to be met with additional buying (thereby creating new support). However, if prices start to drop and move below the previous support area, the reaction becomes just the opposite. All those who bought in the support area now realize that they made a mistake. For futures traders, their brokers are now calling frantically for more margin money.

Because of the highly leveraged nature of futures trading, traders cannot sit with losses very long. They must put up additional margin money or liquidate their losing positions.

What created the previous support in the first place was the predominance of buy orders under the market. Now, howev­er, all of the previous buy orders under the market have become sell orders over the market. Support has become resistance. And the more significant that previous support area was—that is, the more recent and the more trading that took place there—the more potent it now becomes as a resistance area. All of the factors that created support by the three categories of participants—the longs, the shorts, and the uncommitted—will now function to put a ceil­ing over prices on subsequent rallies or bounces.

It is useful once in a while to pause and reflect on why the price patterns used by chartists, and concepts like support and resistance, actually do work. It's not because of some magic pro­duced by the charts or some lines drawn on those charts. These patterns work because they provide pictures of what the market participants are actually doing and enable us to determine their reactions to market events. Chart analysis is actually a study of human psychology and the reactions of traders to changing mar­ket conditions. Unfortunately, because we live in the fast-paced world of financial markets, we tend to rely heavily on chart ter­minology and shortcut expressions that overlook the underlying forces that created the pictures on the charts in the first place. There are sound psychological reasons why support and resistance levels can be identified on price charts and why they can be used to help predict market movements.

Support Becoming Resistance and Vice Versa: Degree of Penetration

A support level, penetrated by a significant margin, becomes a resistance level and vice versa. Figures 4.5a-c are similar to Figures 4.3a and b but with one added refinement. Notice that as prices are rising in Figure 4.5a the reaction at point 4 stops at or above the top of the peak at point 1. That previous peak at point 1 had been a resistance level. But once it was decisively penetrated by

Figure 4.5a In an uptrend, resistance levels that have been broken by a significant margin become support levels. Notice that once resistance at point 1 is exceeded, it provides support at point 4. Previous peaks function as support on subsequent corrections.

Figure 4.5b In downtrend, violated support levels become resistance levels on subsequent bounces. Notice how previous support at point 1 become resistance at point 4.

Figure 4.5c Role reversal at play. Once the early 1997 resistance peak was broken, it reversed roles to become a support level. A year later , the intermediate price decline found support right at the prior resistance peak which had become new support.

wave 3, that previous resistance peak became a support level. All of the previous selling near the top of wave 1 (creating the resis­tance level) has now become buying under the market. In Figure 4.5b, showing declining prices, point 1 (which had been a previ­ous support level under the market) has now become a resistance level over the market acting as a ceiling at point 4.

It was mentioned earlier that the distance prices traveled away from support or resistance increased the significance of that support or resistance. This is particularly true when support and resistance levels are penetrated and reverse roles. For example, it was stated that support and resistance levels reverse roles only after a significant penetration. But what constitutes significant? There is quite a bit of subjectivity involved here in determining whether a penetration is significant or not. As a benchmark, some chartists use a 3% penetration as a criteria, particularly for major support and resistance levels. Shorter term support and resistance areas would probably require a much smaller number, like 1%. In reality, each analyst must decide for himself or herself what con­stitutes a significant penetration. It's important to remember, however, that support and resistance areas only reverse roles when the market moves far enough away to convince the market participants that they have made a mistake. The farther away the market moves, the more convinced they become.

The Importance of Round Numbers as Support and Resistance

There is a tendency for round numbers to stop advances or declines. Traders tend to think in terms of important round num­bers, such as 10, 20, 25, 50, 75, 100 (and multiples of 1000), as price objectives and act accordingly. These round numbers, there­fore, will often act as "psychological" support or resistance levels. A trader can use this information to begin taking profits as an important round number is approached.

The gold market is an excellent example of this phenome­non. The 1982 bear market low was right at $300. The market then rallied to just above $500 in the first quarter of 1983 before falling to $400. A gold rally in 1987 stopped at $500 again. From 1990 to 1997, gold failed each attempt to break through $400. The Dow Jones Industrial Average has shown a tendency to stall at multiples of 1000.

One trading application of this principle is to avoid placing trading orders right at these obvious round numbers. For example, if the trader is trying to buy into a short term market dip in an uptrend, it would make sense to place limit orders just above an important round number. Because others are trying to buy the market at the round number, the market may never get there. Traders looking to sell on a bounce should place resting sell orders just below round numbers. The opposite would be true when placing protective stops on existing positions. As a general rule, avoid placing protective stops at obvious round numbers.

In other words, protective stops on long positions should be placed below round numbers and on short positions, above such numbers. The tendency for markets to respect round num­bers, and especially the more important round numbers previous­ly referred to, is one of those peculiar market characteristics that can prove most helpful in trading and should be kept in mind by the technically oriented trader.