Technical Analysis Explained Read online

  3. The character of intermediate cycles can be used to help identify primary trend reversals.

  4. As an approximate rule, the stronger an intermediate rally, in a bull market the less the retracement is likely to be.

  5 HOW TO IDENTIFY SUPPORT AND RESISTANCE ZONES

  Support and resistance are two basic building blocks of the technical arsenal. They form a key role in price pattern analysis, which we will address later. A lot of people use the term support when they really mean resistance and use resistance when they really mean support. It’s no wonder that there is a lot of confusion. Basically, these are points on a chart where the probabilities favor at least a temporary halt in the prevailing trend.

  Support and Resistance

  In their classic book Technical Analysis of Stock Trends, Edwards and Magee defined support as “buying (actual or potential) sufficient in volume to halt a downtrend in prices for an appreciable period,” and resistance as “selling (actual or potential) sufficient in volume to satisfy all bids and hence stop prices from going higher for a time.”

  A support zone represents a concentration of demand, whereas resistance represents a concentration of supply. The word concentration is emphasized because supply and demand are always in balance. However, it is the relative enthusiasm of buyers as compared to sellers, or vice versa, that is important because that is what determines trends. If buyers are more enthusiastic than sellers, they will continually increase their bids until their purchasing demands have been satisfied. On the other hand, if sellers are the more anxious, then they will be willing to liquidate at lower prices and the general price level will fall. If in doubt, think of support as a temporary floor for prices and resistance as a ceiling.

  At the beginning of Figure 5.1, the price is declining. It finds a bottom at A and then moves up. The next time it falls to A, it again rallies, so A may now be said to be a support area.

  FIGURE 5.1 Support Violation

  This establishes our first principle of support/resistance analysis:

  Major Technical Principle A previous high or low is a potential resistance/support level.

  The third time the price slips to A, it goes through or, as we say, it violates support. One of the first principles of identifying a potential support level, then, is to look for previous lows. In the case of potential resistance, this would be in the area of a previous high.

  Figure 5.2 shows a more extended example. This time, the price found temporary support at B.

  FIGURE 5.2 Support and Resistance Reverse Their Roles

  C also proves to be a support point, but note that the rallies are reversed at support level B. Thus, the second principle is:

  Major Technical Principle Support reverses its role to resistance on the way up.

  Just think of it this way: A floor in a building acts as a support zone, but when you fall through it, the floor now becomes resistance, called a ceiling. The reason why support and resistance reverse their roles can be appreciated with an explanation of some elementary psychology. No one likes to take a loss, and while some people overcome this feeling by cutting their losses at an early stage, others hold on until the price comes back to where the security in question was originally bought. At that point, they are able to break even and sell, thereby creating a quantity of supply sufficient to temporarily halt the advance.

  Finally, in Figure 5.3, we see the price rally through resistance at B and A (the former support level). The ensuing decline then finds support at A again. Thus, our third principle is:

  FIGURE 5.3 Support and Resistance Reverse Their Roles

  Major Technical Principle Resistance reverses its role to support on the way down.

  Rules for Determining Potential Support/Resistance Points

  Previous Highs and Lows

  We have already established that previous highs and lows are potential support or resistance levels. Highs are important because many market participants may have bought close to or at the actual high for a move. When prices decline, the normal human response is not to take a loss, but to hold on. That way, the pain of actually realizing a loss can be avoided. As a result, when the price returns to the old high, those who bought at that level have great motivation to sell in order to break even. Consequently, they liquidate. Also, those who bought at lower prices have a tendency to take profits at the old high, since that is the top of familiar ground. By the same token, any prices above the old high look expensive to potential buyers; consequently, there is less enthusiasm on their part, so they begin to pull away from the market.

  When a price rallies and then falls back to the previous low, these bargain-basement prices appeal to potential buyers. After all, they missed the opportunity the first time prices retreated to this level, and they are therefore thankful to have another chance. For the same reason, sellers are reluctant to part with their securities as prices approach the previous low, since they saw them bounce before and naturally wonder why the same process should not be repeated.

  Chart 5.1 shows the sugar price for a period spanning 2002–2003.

  CHART 5.1 March 2003 Sugar Daily

  Note how previous highs and lows offer good support/resistance points for future trading. Unfortunately, there is no way of knowing whether a particular level will turn out to be support or resistance, or even whether it will be a pivotal point at all. That’s why these are merely intelligent places for anticipating a temporary reversal. Resort to other indicators such as oscillators is therefore required.

  At Round Numbers

  Support and resistance zones have a habit of forming at round numbers. This is probably because numbers such as 10, 50, or 100 represent easy psychological points upon which traders and investors often base their decisions. In the 1970s, for example, the Dow Jones Industrials had a great deal of difficulty surpassing the 1,000 level. For gold in the 1980s and mid-1990s, the magic number was $400, and so forth. The guide for potential turning points, then, is to look for round numbers.

  Trendlines and Moving Averages Represent Dynamic Levels of Support and Resistance

  Chapter 6 points out that a good trendline should reflect the underlying trend. One of the rules for assessing the significance of a line relates to how many times it has been touched or approached. The more, the merrier in this case. If a price falls back to a specific low on several occasions, this makes that particular price level a strong support zone. The same is true of trendlines and moving averages (MAs). Every time a price moves back to an up trendline or a rising MA and bounces, it is reinforced as a dynamic level of support. The same would be true in reverse for a declining trend-line or moving average. Therefore, it makes sense to buy as the price falls to an up trendline (or rising MA) and to sell when it rises to a down trendline (or falling MA). A low-risk stop may then be placed just beyond the line or MA in case the support/resistance zone is violated.

  Chart 5.2 shows a very good example of how a down trendline acted as resistance for Hewlett-Packard.

  CHART 5.2 Hewlett-Packard Daily

  Note also that the interaction of a reliable MA, such as the 200-day MA featured in this chart, acts as reinforcement of the resistance zone. This works in the same way as if we were building a house and doubled the thickness of the roof. The identical principle holds when a moving average and a trendline are at the same level; they double the strength of the resistance (or support in the case of an up trendline and MA intersection).

  Emotional Points on a Chart Represent Potential Support/Resistance Levels

  This concept will be covered in subsequent chapters when we consider gaps, extreme points of Pinocchio bars, two-bar reversals, key reversals, and so forth. For the moment, suffice it to say that most emotional points are those at which a price, following a persistent trend, experiences a strong extension of that trend. During the course of the bar’s formation, it then abruptly reverses direction. It’s the abruptness of the reversal that is the key since it tells us, depending on the direction, that either bu
yers or sellers are exhausted. When that point in the chart is again revisited, it often forms a barrier to further progress—in other words, a support or resistance level.

  Gaps represent another example of emotional points. They are formed when buyers or sellers respond so emotionally to news that a blank space, or gap, is left on the chart. In Chart 5.3, probably because of unexpected bad news, the sugar price experiences three downside gaps.

  CHART 5.3 March 2003 Sugar Daily Resistance

  Later on, when emotions become more stable, the price rallies and tries to “close” each of the gaps. In the case of the gap on the left, resistance is found at its opening. In the other two examples, resistance forms at the lower part of the gap. Gaps are one of the most reliable technical concepts from the point of view of projecting potential support or resistance areas. We see some good examples in 2011 for the Market Vectors Coal exchange-traded fund (ETF) (Chart 5.4), where the small rectangles highlight the gaps and the horizontal lines represent the high and low for the gap, with their obvious support implications.

  CHART 5.4 Market Vectors Coal ETF (KOL)

  Chart 5.5 shows another emotional point for Boeing. This time, it’s the bottom of a very wide bar in early 2002. Note that this low developed at a round number, $50.

  CHART 5.5 Boeing Weekly

  Normally, this would have been a support level the next time the price fell to $50, but in the fall of 2002, the price went right through it. Even so, $50 did turn out to be a pivotal point the next time Boeing rallied. It goes to show that even if a support/resistance zone is violated once, it can still turn out to be a pivotal point in subsequent price action.

  Proportionate Moves, Retracements, and So On

  The law of motion states that for every action, there is a reaction. Price trends established in financial markets are really the measurement of crowd psychology in motion, and are also subject to this law. These swings in sentiment often show up in proportionate price moves.

  Perhaps the best-known principle of proportion is the 50 percent rule. For instance, many bear markets, as measured by the Dow Jones Industrial Average (DJIA), have cut prices by half. As examples, the 1901–1903, 1907, 1919–1921, and 1937–1938 bear markets recorded declines of 46, 49, 47, and 50 percent, respectively. The first leg of the 1929–1932 bear market ended in October 1929 at 195, just over half the September high. The halfway mark in an advance sometimes represents the point of balance, often giving a clue to the ultimate extent of the move in question or, alternatively, indicating an important juncture point for the return move. Thus, between 1970 and 1973, the Dow advanced from 628 to 1,067. The halfway point in that rise was 848, or approximately the same level at which the first stage of the 1973–1974 bear market ended.

  By the same token, rising markets often find resistance after doubling from a low; the first rally from 40 to 81 in the 1932–1937 bull market was a double.

  In effect, the 50 percent mark falls in the middle of the one-third to two-thirds retracement described in Chapter 2 in the discussion of peak-and-trough progression. These one-third and two-thirds proportions can be widely observed in all securities, and also serve as support or resistance zones.

  Ratio-scale charts are helpful in determining such points, since moves of identical proportion can easily be projected up and down. Moreover, these swings occur with sufficient consistency to offer possible reversal points at both peaks and troughs. Remember, technical analysis deals with probabilities, which means that forecasts should not be made using this method in isolation.

  In addition, when undertaking a projection based on the rules of proportion, it is always a good idea to see whether the price objective corresponds to a previous support or resistance point. If it does, the odds are much higher that this zone will represent a reversal point, or at least a temporary barrier. When a security price is reaching new all-time high ground, another possibility is to try to extend up trendlines. The point at which the line intersects with the projection using the rules of proportion may well represent the time and place of an important reversal. Experimentation will show that each security has a character of its own, with some lending themselves more readily to this approach and others not at all.

  Chart 5.6 shows an example using one-third, two-thirds, and 50 percent retracements for the PowerShares Dynamic Insurance ETF.

  CHART 5.6 PowerShares Dynamic Insurance ETF (PIC)

  In this instance, the decline from the 100 percent line to the 0 percent line (A) is 100 percent of the move. If we want to establish possible resistance points for subsequent rebounds, then the intelligent places to monitor are these one-third, two-thirds, and 50 percent retracements. As you can see, the rally ending at B, C, and D represent a 33 percent, 50 percent, and 66 percent or two-thirds retracement, respectively. These pivot levels remain in force once surpassed. You can see this from the decline at E, which was halted at the 33 percent mark. While we do not know ahead of time when these retracement moves will halt at the one-third, 50 percent, or two-thirds pivotal points, we can certainly get some clues by examining some of the other technical indicators as the price approaches these junctures to see if things are, in fact, consistent with a turn.

  Many technicians use a sequence of numbers discovered by Leonardo Fibonacci, a thirteenth-century Italian mathematician. The sequence has many properties, but a key one is that each new number is the sum of the two previous numbers in the series. Thus, 5 and 8 = 13, 8 and 13 = 21, and so on. The significance of this sequence for our purposes is that it offers some guidelines for proportionate moves. For example, each number in the sequence is 61.8 percent of the next number, 38.2 percent of the number after that, and so forth.

  In this respect, Charts 5.7 and 5.8 show some possibilities for the silver ETF. The retracement moves are measured in exactly the same way as in the previous chart, except that Fibonacci numbers have been substituted.

  CHART 5.7 Silver ETF

  CHART 5.8 Silver ETF

  In the case of Chart 5.7, the initial rally was halted at the 23.6 percent level, the next at 50 percent, and the third move up at a level just shy of 61.8 percent of the March to September 2008 decline. We can also see that an advance was held at the 50 percent mark at E and at the 61.8 percent level either side of F. In Chart 5.8, we see how the 38.25 level comes into play a couple of times and the value of a gap opening as two rallies were turned back at B and later at D. Note this very same level was reinforced as a pivotal point, not only because of its importance as a gap opening, but also as a 38.2 percent retracement level, as we can see at D. Finally, previous lows as a support-generating principle came into their own at C.

  Chart 5.9 shows the same principle applied to upside projections.

  CHART 5.9 Palladium

  Once again, AB represents 100 percent of the decline and lines are drawn at upside Fibonacci proportions. In this case, the next higher number divided by the current number is 1.61, then 2.61, and so on. It is self-evident how the 161.8 percent and 261.8 percent proportions become key pivotal points in future price action. Once again, these levels are not guaranteed to become important pivotal points, but are intelligent places on the chart to anticipate that possibility.

  Rules for Determining the Probable Significance of a Potential Support or Resistance Zone

  At this point, you are probably asking, “How do I know how important each support and resistance level is likely to be?” Unfortunately, there is no hard-and-fast answer, but there are some general rules that can act as guidelines.

  The Amount of a Security that Changed Hands in a Specific Area—the Greater the Activity, the More Significant the Zone

  This is fairly self-evident, for whenever you have a large number of people buying or selling at a particular price, they have a tendency to remember their own experiences. Buyers, as we have already established, like to break even. Sellers, on the other hand, may have bought lower down and recall that prices previously stalled at the resistance level. Their motivation for pro
fit-taking becomes that much greater.

  The Greater the Speed and Extent of the Previous Move, the More Significant a Support or Resistance Zone Is Likely to Be

  The attempt to climb through the resistance level here can be compared to the efforts of a person who tries to crash through a door. If he attacks the door from, say, 10 or 12 feet away, he can propel himself with lots of momentum, and the door will probably give way. On the other hand, if he begins his attempt from 100 feet away, he will arrive at the door with less velocity and will probably fail in his attempt. In both cases, the door represented the exact same resistance, but it was the resistance relative to the velocity of the person that was important. The same principle can be applied to the market, in that a long, steep climb in price is similar to the 100-foot run, and the resistance level resembles the door. Consequently, the more overextended the previous price swing, the less the resistance or support that is required to halt it. Also, the faster a price moves on the upside, the more willing traders will be to take a quick profit. On the other hand, an abrupt move to the downside will make the price appear as that much more of a bargain than if it had slowly drifted lower.