SUPPORT AND RESISTANCE

SUPPORT AND RESISTANCE

A ball hits the floor and bounces. It drops after it hits the ceiling. Support and resistance are like a floor and a ceiling, with prices sandwiched between them. Understanding support and resistance is essential for understanding price trends and chart patterns. Rating their strength helps you decide whether the trend is likely to continue or to reverse.

Support is a price level where buying is strong enough to interrupt or reverse a downtrend. When a downtrend hits support, it bounces like a diver who hits the bottom and pushes away from it. Support is represented on a chart by a horizontal or near-horizontal line connecting several bottoms.

Resistance is a price level where selling is strong enough to interrupt or reverse an uptrend. When an uptrend hits resistance, it stops or tumbles down like a man who hits his head on a branch while climbing a tree. Resistance is represented on a chart by a horizontal or near-horizontal line connecting several tops.

It is better to draw support and resistance lines across the edges of congestion areas instead of extreme prices. The edges show where masses of traders have changed their minds, while the extreme points reflect only panic among the weakest traders.

Minor support or resistance causes trends to pause, while major support or resistance causes them to reverse. Traders buy at support and sell at resistance, making their effectiveness a self-fulfilling prophecy.

example: British Pound Support and Resistance

Draw horizontal lines through the upper and lower edges of congestion areas. The bottom line marks the support-the level at which buyers overpower sellers. The upper line identifies resistance, where sellers overpower buyers. Areas of support and resistance often switch their roles. Note how the level of support in March became the line of resistance in May. The strength of these barriers increases each time prices touch them and bounce away.

Beware of false breakouts from support and resistance. The letter F marks false breakouts on this chart. Amateurs tend to follow breakouts, while professionals tend to fade (trade against) them. At the right edge of the chart, prices are hitting strong resistance. This is the time to look for a shorting opportunity, with a protective stop slightly above the line of resistance.

Memories, Pain, and Regret
Support and resistance exist because people have memories. Our memories prompt us to buy and sell at certain levels. Buying and selling by crowds of traders creates support and resistance.

If traders remember that prices have recently stopped falling and turned up from a certain level, they are likely to buy when prices approach that level again. If traders remember that an uptrend has recently reversed after rising to a certain peak, they tend to sell and go short when prices approach that level again.

For example, all major rallies in the stock market from 1966 until 1982 ended whenever the Dow Jones Industrial Average rallied to 950 or 1050. The resistance was so strong that traders named it "A Graveyard in the Sky". Once the bulls rammed the market through that level, it became a major support area.

Support and resistance exist because masses of traders feel pain and regret. Traders who hold losing positions feel intense pain. Losers are determined to get out as soon as the market gives them another chance. Traders who missed an opportunity feel regret and also wait for the market to give them a second chance. Feelings of pain and regret are mild in trading ranges where swings are small and losers do not get hurt too badly. Breakouts from trading ranges create intense pain and regret.

When the market stays flat for a while, traders get used to buying at the lower edge of the range and shorting at the upper edge. In uptrends, bears who sold short feel pain and bulls feel regret that they did not buy more. Both feel determined to buy if the market gives them a second chance. The pain of bears and regret of bulls make them ready to buy, creating support during reactions in an uptrend.

Resistance is an area where bulls feel pain, bears feel regret, and both are ready to sell. When prices break down from a trading range, bulls who bought feel pain, feel trapped, and wait for a rally to let them get out even. Bears regret that they have not shorted more and wait for a rally to give them a second chance to sell short. Bulls pain and bears regret create resistance - a ceiling above the market in downtrends. The strength of support and resistance depends on the strength of feelings among masses of traders.

Strength of Support and Resistance
A congestion area that has been hit by several trends is like a cratered battlefield. Its defenders have plenty of cover, and an attacking force is likely to slow down. The longer prices stay in a congestion zone, the stronger the emotional commitment of bulls and bears to that area. When prices approach that zone from above, it serves as support. When prices rally into it from below, it acts as resistance. A congestion area can reverse its role and serve as either support or resistance.

The strength of every support or resistance zone depends on three factors: its length, its height, and the volume of trading that has taken place in it. You can visualize these factors as the length, the width, and the depth of a congestion zone.

The longer a support or resistance area - its length of time or the number of hits it took-the stronger it is. Support and resistance, like good wine, become better with age. A 2-week trading range provides only minimal support or resistance, a 2-month range gives people time to become used to it and creates intermediate support or resistance, while a 2-year range becomes accepted as a standard of value and offers major support or resistance.

As support and resistance levels grow old, they gradually become weaker. Losers keep washing out of the markets, replaced by newcomers who do not have the same emotional commitment to old price levels. People who lost money only recently remember full well what happened to them. They are probably still in the market, feeling pain and regret, trying to get even. People who made bad decisions several years ago are probably out of the markets and their memories matter less.

The strength of support and resistance increases each time that area is hit. When traders see that prices have reversed at a certain level, they tend to bet on a reversal the next time prices reach that level.

The taller the support and resistance zone, the stronger it is. A tall congestion zone is like a tall fence around a property. A congestion zone whose height equals 1 percent of current market value (four points in the case of the S&P 500 at 400) provides only minor support or resistance. A congestion zone that is 3 percent tall provides intermediate support or resistance, and a congestion zone that is 7 percent tall or higher can grind down a major trend.

The greater the volume of trading in a support and resistance zone, the
stronger it is. High volume in a congestion area shows active involvement
by traders - a sign of strong emotional commitment. Low volume shows that
traders have little interest in transacting at that level - a sign of weak support
or resistance.

Trading Rules

1. Whenever the trend you are riding approaches support or resistance, tighten your protective stop. A protective stop is an order to sell below the market when you are long or to cover shorts above the market when you are short. This stop protects you from getting badly hurt by an adverse market move. A trend reveals its health by how it acts when it hits support or resistance. If it is strong enough to penetrate that zone, it accelerates, and your tight stop is not touched. If a trend bounces away from support or resistance, it reveals its weakness. In that case, your tight stop salvages a good chunk of profits.

2. Support and resistance are more important on long-term charts than on short-term charts. Weekly charts are more important than dailies. A good trader keeps an eye on several timeframes and defers to the longer one. If the weekly trend is sailing through a clear zone, the fact that the daily trend is hitting resistance is less important. When a weekly trend approaches support or resistance, you should be more inclined to act.

3. Support and resistance levels are useful for placing stop-loss and protect-profit orders. The bottom of a congestion area is the bottom line of support. If you buy and place your stop below that level, you give the uptrend plenty of room. More cautious traders buy after an upside breakout and place a stop in the middle of a congestion area. A true upside breakout should not be followed by a pullback into the range, just as a rocket is not supposed to sink back to its launching pad. Reverse this procedure in downtrends.

Many traders avoid placing stops at round numbers. This superstition began with off-the-cuff advice by Edwards and Magee to avoid placing stops at round numbers because "everybody" was placing them there. Now, if traders buy copper at 92, they place a stop at 89.75 rather than 90. When they sell a stock short at 76, they place a protective stop at 80.25 rather than 80. These days there are fewer stops at round numbers than at fractional numbers. It is better to place your stops at logical levels, round or not.

True And False Breakout
Markets spend more time in trading ranges than they do in trends. Most breakouts from trading ranges are false breakouts. They suck in trend-followers just before prices return into the trading range. A false breakout is the bane of amateurs, but professional traders love them.

Professionals expect prices to fluctuate without going very far most of the time. They wait until an upside breakout stops reaching new highs or a downside breakout stops making new lows. Then they pounce - they fade the breakout (trade against it) and place a protective stop at the latest extreme point. It is a very tight stop, and their risk is low, while there is a big profit potential from a pullback into the congestion zone. The risk/reward ratio is so good that professionals can afford to be wrong half the time and still come out ahead of the game.

The best time to buy an upside breakout on a daily chart is when your analysis of the weekly chart suggests that a new uptrend is developing. True breakouts are confirmed by heavy volume, while false breakouts tend to have light volume. True breakouts are confirmed when technical indicators reach new extreme highs or lows in the direction of the trend, while false breakouts are often marked by divergences between prices and indicators.


- Trading For A Living (Dr. Elder)