Understanding stage development is a natural lead-in to the discussion of support and resistance. Support and resistance are not literal lines on the chart or an exact destination, but are more accurately defined as “areas” of support and resistance. This translates into areas of buying (stages 1 and 2) and areas of selling (stages 3 and 4). Defining support and resistance on the charts will now allow a trader and investor to take the next step in top-down analysis. Our objective in this chapter is to start seeing support and resistance on all timeframes that will lead to actionable trades. This chapter is truly the foundation of technical analysis.
The ongoing battle between bulls and bears is what makes the stock market such a fascinating study of the basic laws of supply and demand. By using technical analysis to study how a stock reacts to these battles, you can be poised to participate in a continued trend. Support and resistance levels are one of the most important forces in technical analysis because they are the building blocks upon which trends are built.
Support levels, are areas where there is enough buying pressure (demand) to offset selling pressure (supply) and provide a temporary halt to declines. Support levels represent the “demand half” of the supply/demand equation. Support levels are like a trampoline. Whenever prices drop to a level of support, buyers overwhelm sellers and the stock bounces higher. Certainly support can also be defined as an area where price declines are halted without the bounce, but strong support and typical market action represents the trampoline analogy versus what some call a “dead cat bounce.” Therefore we expect upside elasticity at support, not rigor mortis! Rallies that fail to appear at the expected support call the level into question. It is important to remember that support on longer-term charts tends to be defined as a range in price (area of support), rather than a specific number. However, on short-term timeframes, support is often a very specific price. In both cases, defining support will be very helpful in timing trade entries. By increasing the accuracy of the entry, you not only have greater profit potential, but more importantly, you are assured that if that market doesn’t agree with your analysis, then any losses will be small and the discomfort of heat (withstanding a losing position) will be minimized.
Resistance levels are areas where selling pressure (supply) offsets buying pressure (demand) and halts advances in the price of stocks. Resistance represents the other side of the supply/demand equation—the barrier of supply. Resistance levels are like a rubber ceiling where sellers overwhelm the buying pressure and the stock retreats. Much like supply, resistance on longer-term timeframes tends to be an area and not a specific number. Just as shorter-term support levels are often a specific number, the same is true for resistance in short-term charts. Zooming into shorter-term timeframes allows you to find key resistance levels with a greater degree of accuracy. This is because the close-up view can show intraday volatility where the security may have run into support or resistance several times during the day. On a longer-term chart it would be seen as only one test of the level. Figure 8-1 is an example of support and resistance.
FIGURE 8 - 1 The chart shows an example of support and resistance on an hourly chart.
The psychology of support and resistance can be defined in many ways, but this example helps make the point. Have you ever bought a stock only to watch it decline in price and wish you could go back in time and get out in time to break even? This type of buyer’s remorse shows up on the chart as resistance. Obviously, one person’s position will not offer much resistance, but when prices are at a level where many people are involved with the stock, the selling pressure is multiplied and so is the resistance. At these levels we refer to participants as “weak holders of stock.” It becomes much harder for the security to work through the increased supply before moving higher. What makes a good support or resistance level? It depends on how much time the security spent at that particular level and how many transactions took place. This can be verified by looking at ranges and volume.
Have you ever sold a stock after it has done nothing for months and then watched it immediately move higher without you, as if the market mysteriously knew you exited the position? Of course this doesn’t really happen, but you probably wish you could buy back the stock at your original price. These actions, repeated by many buyers and sellers, form support for a stock price because as a stock pulls back toward that prior resistance level there is demand from those who wished they hadn’t missed the first chance to buy at those initial levels. In fact, what often occurs is that stock does not pull all the way back to prior resistance since demand can be impatient and anxious participants respond early (think greed).
The more often support or resistance is tested, the more likely that level is to fail. After multiple assaults on the sellers of a stock at a resistance level, supply will eventually be overwhelmed and the stock will experience an upside “breakout.” Put simply, when demand exceeds supply, the stock is free to move higher. The more times support is tested, the more likely it will fail to hold. Think of these levels as fences. The more they get bumped, the weaker they become. When selling pressure exceeds demand, it creates lower lows and a continuing downtrend. Breakouts and breakdowns are a popular way to trade because they often lead to dramatic short-term moves with strong velocity.
One of the better clues that a breakout or breakdown is coming is when an increase in the frequency of support and resistance is tested. For example, suppose a stock in an uptrend finds resistance at the $40 level and pulls back to $35 and tests the $40 level again eight days later. At this test of the $40 level, the stock pulls back to a higher low at the $37 level. Then the stock once again makes a test of the $40 level, only to pull back to the $39 level. The buyers are getting more aggressive each time the stock retraces from each successive test of the $40 level. The impatience to own the stock shows that buyers are getting control. The buyers show their tenacity not only through price but also through time. The second test of the resistance level comes after four days compared to the first test at eight days. The last test is after only two days (the fence is getting bumped often and with less rest between assaults). Each test of the $40 level reduces the supply offered at that level, making a breakout imminent. The inability of the stock to retrace more than $1 indicates supply (those who drive the price down by hitting bids) is beginning to be removed. Once the passive supply (offered at $40) is freed up, the stock can move higher. At this point there will typically be a large surge in volume as the last of the $40 stock is bought, and the stock experiences a breakout that sees the stock move up to $45 in just a couple of days. It sounds easy—buy support and sell resistance—but if this were not the case, the stock would just go sideways.
What happens when support is broken? Once broken, support becomes resistance. If a stock has been trading at a valid support level for a long period of time and suddenly breaks through that level, then support tends to act as resistance in the future. Many people who bought at the support lost money as the stock broke down. These people have the “just want to get out even” syndrome. Many times these participants do not use protective stops below the support level. They become emotional and hold onto the stock until shares get back to the level where they entered. As they attempt to sell their stock, new supply is created. Refer to Figure 8-2 for an example of a stock that broke support then became resistance.
FIGURE 8 - 2 Support, once broken, tends to act as resistance.
Once broken, the resistance becomes support. For example, let’s say you own stock that has traded within a range for a long period of time. Since the stock is not doing anything, you exit the trade. As soon as you exit the position, the stock breaks out of the range and starts to move higher. In the back of your mind you are angry and think that if it only comes back to that range, you will jump back in, since you want to participate in the move and you want your old price. This thinking creates an underlying demand for the stock as it pulls back to a level that was prior resistance. It is a sort of “revenge syndrome” whereby the participant needs to validate that they were originally right and acted accordingly. We can again apply psychology (personal in this instance) to the market. Another source of demand comes from traders who shorted the stock as it came to the top of the range. As the stock breaks higher from this level, the shorts lose money. As these participants who were short hold onto their positions, they hope for the stock to pull back to the resistance that was previously broken. These people who were short must buy their stock back in order to exit their positions. This creates an underlying demand for the stock at the prior resistance level. This is how resistance, once broken, becomes support as this process is repeated over and over again as the stock moves higher. Figure 8-3 is an example of how once broken, resistance becomes support.
FIGURE 8 - 3 Once resistance has been broken, it becomes support. Typically, the strongest signals occur when the pullback does not equal the prior resistance since anxious buyers act promptly.
Your goal as an investor or active trader should be to take money out of the stock market on a consistent basis. The most important thing you can do to make this possible is to trade with the trend. Trends are another one of the foundations that technical analysis is built upon and should be considered the backbone to developing a directional bias.
If you enter the trade at an appropriate time within a trending stock, a trader then has the greatest probability of making larger profits and at the same time helps to formulate intelligent levels for protective stops. Once a trend is established, the security is more likely to continue in its original direction than to reverse. This is the path of least resistance (different context in the definition of resistance). Even the strongest stocks don’t go straight up. They tend to move in a stair-step fashion, defined by a series of peaks and troughs. It is the direction of these highs and lows that determines the overall trend.
When a stock enters the stage 2 markup phase, it is in an uptrend defined by a series of higher highs and higher lows. Each time a stock in an uptrend pulls back after getting ahead of itself, it finds support at a level higher than the last time it experienced profit-taking. Pullbacks in uptrends provide ideal entry points to enter long positions. See Figure 8-4 for a stock in an uptrend.
FIGURE 8 - 4 This stock broke out of a stage 1 pattern and transitioned into a stage 2 uptrend making higher highs and higher lows.
It is important to recognize that there are trends within trends and the longer-term trend is the sum of all the short-term trends. As noted earlier, look to long-term trends to indicate the overall direction of the security and the shorter-term trend to refine your entry points.
The downtrend is the reverse of an uptrend and it is found in the stage 4 decline of a stock cycle. A downtrend is defined by a security making a series of lower highs and lower lows. When a stock breaks down to new lows, the subsequent rally will take the stock up to a level that does not exceed the previous rally high. Each time the sellers take control, the stock price makes a lower low.
Downtrending stocks show a series of sell-offs followed by rallies that fall short of the prior high. These rallies give short sellers an opportunity to profit in declining stocks. Stocks in a downtrend tend to trade more on emotion than an uptrending stock. This is because people become complacent when things are going well and fearful when things are not. When people are fearful of losing money, the subsequent price action can have a high velocity and this is where all the money is made for the short seller. See Figure 8-5.
FIGURE 8 - 5 Note the lower lows and lower highs this stock makes as it trends lower.
Many times market participants attempt to get long stocks that are in a downtrend. They may do this because they feel the stock has been beaten down too much or that it is a good value at this low price. It is important to note that the trend is your friend, and by fighting the downtrend, you will lose money. With that said, there is never a good time to a get long stock that is in a downtrend. The risk is simply not worth it.
While the market may have consensus in that it has moved with the trend, it is sometimes difficult to see trend if volatility is high. By taking the average of the consensus, the trend of the stock can be easily noted. The tool to smooth out the consensus is the moving average (MA).
MAs are one of the most versatile and widely used of all technical tools. They are the backbone for most trend-following systems because of the ease of their construction and the fact that moving averages can be so readily tested. The MA is also the basis for many popular oscillators (a tool that will be discussed in Chapter 16) and indicators. A trend-following device smoothes out the noise that price data can produce, and this makes it easier to recognize and gauge the strength of the underlying trend.
Construction of a simple MA is calculated by adding the closing prices of the period being studied and dividing the total by the number of periods being studied. In the case of the daily MA, on each successive day the data for the new day is added to the total after the first day is dropped off, and again divided by the amount of days for which the study is being calculated. Because MAs represent the smoothed trend of the market or security it is following, it makes sense that a rising MA represents a rising trend and a declining MA represents a downtrend. See Figure 8-6.
FIGURE 8 - 6 Notice how the 20-period MA follows the price closer than the 50-period MA, which follows closer than the 100-period MA.
When you adjust the period of the MA, you adjust the fast and slow MAs. If you shorten the period of the MA, it speeds up since it is more influenced by current prices. This means that it tracks the security more closely because each point of data that gets added and each point of data that gets dropped off now has a greater influence on the overall MA. In the reverse case when you lengthen the period of the MA, you are taking relatively more pieces of data into account. When the MA has many points of data involved in its calculation, one piece of data has less effect on the MA as a whole. If a slower MA is moving higher, the long-term consensus for the stock is bullish. If the faster MAs are trending higher, the stock has near-term strength and there is an urgency to own the stock.
A common way that investors and traders use MAs is to place trailing stop orders (orders that will get you out of a position) just under an MA as the security progresses in an uptrend. The reason for placing a stop under a rising MA is that it is thought that as long as the price remains above the MA it will continue to pull the MA higher and remain in its trend. By practicing this technique, you are able to remain in a position while it is trending strongly. In the case of a short sale, the stop is placed just above a declining MA, since the declining MA confirms the downtrend.
Another common MA strategy that many investors and traders observe are “crossovers” of a shorter-term and longer-term moving averages. A crossover is a method that uses two MAs—such as a short-term 10-day MA and a longer-term 20-day MA. The 10-day moving average is faster because it uses less periods in its calculation and it follows spontaneous price action closer than the slower MA, which takes considerably more data in its calculation. A crossover system in theory buys when the faster 10-day MA crosses up through the slower 20-day MA or sells as the 10-day MA crosses down through the slower 20-day MA. A bullish crossover can typically be found after the stock has experienced a sell off and the stock begins to move higher again especially when other indications support the direction of trend such as movement into stage 2.
The interpretation of such a crossover is that once the shorter-term trend has exceeded the longer-term trend, prices can continue higher because the trends confirm each other. When you add a third MA, like a 50-day MA, a bullish crossover would occur when the 10-day MA pierces a 20-day MA and the 20-day MA is above the 50-day MA. What this really represents is agreement among market participants about the trend of the stock. It is better to have agreement between the trends of the short-term (10-day MA), intermediate-term (20-day MA), and longer-term trend (50-day MA). This is because it shows that the path of least resistance is consistent among various participants with different objectives and time horizons whose decisions to buy and sell are keyed to these MAs. A bearish crossover can usually be found as the stock heads from a stage 3 distribution top into a stage 4 decline regardless of the timeframe being studied.
When you apply MA analysis to the four stages of the stock market, you can gain some insight into your stage identification. See Figure 8-7.
FIGURE 8 - 7 Notice that while this security is in stage 4 decline, the 20-day MA is below the 50-day MA, which is below the 100-day MA. In a stage 1 accumulation, the MAs are going sideways, and while the stock is in a stage 1 accumulation, the 20-day MA is above the 50-day MA, which is above the 100-day MA.
In a stage 2 markup phase, the MAs should be trailing higher with the shorter-term MAs above the longer-term MAs and the stock price above all the MAs. There is a clear consensus that there is demand for the stock as the price moves higher. If any significant pullback occurs, you can tell the strength of the trend by which MAs the stock price holds above.
A stock that is in a stage 3 distribution pattern has the MAs crossing back and forth over one another indicating lack of trend. The crisscrossing of MAs shows that there is no clear consensus, hence confirmation of stage 3. It is not until the MAs establish a clear pattern before action can be taken.
As a stock enters a stage 4 decline, ideally the stock price is below the MAs and the faster MAs are below the longer-term MAs. This shows that the consensus is the stock moving lower. Even if the stock does begin to move higher, it should find resistance at the different MAs.
In the stage 1 accumulation phase, the MAs also cross back and forth over one another. Since the stock is moving sideways, there is no trend and that is exactly what the MAs are telling us—no consensus, therefore no action.
Depending on the timeframe that you are trading on, the MAs should be adjusted so that the appropriate trend is revealed. See Figure 8-8.
FIGURE 8 - 8 These are the suggested MA periods for several timeframes.
Like any other indicator, MAs should be used with care and not used as a stand-alone indicator for entering or exiting trades. Since MAs use data that has already happened, they are a lagging indicator and must be used with care in predicting the future.
As we move to Chapter 9, we can start to apply the confluence of ideas to form analysis that confirms a directional bias within a primarily stage 2 or stage 4 cycle. Market structure, as represented in stage analysis, support and resistance, and moving averages, form powerful indications of future market action. But caution must be given once again that nothing is perfectly literal. Stage 1 does not mean stage 2 will immediately follow, just as stage 3 does not always predict stage 4.
In Chapter 9, we discover chart formations and patterns that fall into two major categories: continuation patterns and reversal patterns. These patterns help define the propensity for a stock, sector, or indice to either continue its prior stage or transition and reverse. With this understanding, traders and investors can increase their odds again by understanding when to stay with the prevailing trend or when to expect a new trend to emerge. When these structures within the market all point to the same analysis, we can then act on our plan with clarity and confidence while reducing risk.
