Basics of Trading (2) – Support and Resistance

Following on from the previous post on initial setup and charting.

Once you have access to charts you will want to start to understand how to look at them. As I wrote previously:

The higher timeframes (daily, 4 Hour, 1 hour) will give you a good idea what is happening.

(You should of course also be aware of the weekly, monthly and yearly levels).

You will hear all sorts trading advice repeated over and over. None is as common as “support becomes resistance and resistance becomes support”.

Basic support and resistance looks like this:

supp_res

Here is an example with a EURUSD daily chart:

The orange lines show Support and Resistance at a daily level. Price broke out in February but retraced back into the prior range. It found support at 1.28 and resistance again at 1.34 again in June-September. It broke above with a huge overnight move in September and extended to new 2 year highs. 1.34 is the obvious place for what is known as a “retest”.

The Euro was under selling pressure due to Greece/Cyprus when Mario Draghi announced in April that the ECB will do all it takes to support the Euro. He gave a warning to trader to not short the Euro. It was a no brainer but some people find it impossible to get long the Euro, focusing on the negative instead of the positives and the greatest one being the German industrial machine.

The Euro was under selling pressure due to Greece/Cyprus when Mario Draghi announced in April that the ECB will do all it takes to support the Euro. He gave a warning to trader to not short the Euro. It was a no brainer but some people find it impossible to get long the Euro, focusing on the negative instead of the positives and the greatest one being the German industrial machine.

The black boxes I have drawn on the chart are there to illustrate how “large ranges often give way to small ranges”. These are the words of Larry Williams (see https://atoast2trading.wordpress.com/2012/02/24/larry-williams-long-term-secrets-to-short-term-trading/) for more info.

I also put them there to illustrate another point. I think it was Paul Tudor Jones who said “if the market makes a large move in one direction it is sending you a powerful message”.

Some further explanation on support and resistance levels by Josh Lukeman in his book “The Market Makers edge”:

support_resistance

Market moves are often lightning quick based on some news even and are then followed by lots of sideways action, known as choppyness. Some say choppy like the sea, others because it chops your account up when you trade with tight stops. The market frequently only moves up and down a small bit over a period of days/weeks sucking in traders on either side in fakeout moves causing traders to chase price higher or lower and get trapped. These moves are created and taken advantage of by professionals who are looking for small moves on a daily basis while waiting for larger moves.

This is from a book called “New Frontiers in Technical Analysis” and explains what is happening:

market_particpants

I would suggest getting a copy of Jesse Livermore Reminiscences Of a Stock Operator. It is very popular with traders and a timeless classic. Livermore himself was known as the “boy plunger” because he used to like to “swing a large line from the short side”.

Something from that book which explains further how support and resistance works:

Nobody should be puzzled as to whether a market is a bull or a bear market after it fairly starts. The trend is evident to a man who has an open mind and reasonably clear sight, for it is never wise for a speculator to fit his facts to his theories. Such a man will, or ought to, know whether it is a bull or a bear market, and if he knows that he knows whether to buy or to sell. It is therefore at the very inception of the movement that a man needs to know whether to buy or to sell. Let us say, for example, that the market, as it usually does in those between swings times, fluctuates within a range of ten points; up to 130 and down to 120. It may look very weak at the bottom; or, on the way up, after a rise of eight or ten points, it may look as strong as anything. A man ought not to be led into trading by tokens. He should wait until the tape tells him that the time is ripe. As a matter of fact, millions upon millions of dollars have been lost by men who bought stocks because they looked cheap or sold them because they looked dear.

The speculator is not an investor. His object is not to secure a steady return on his money at a good rate of interest, but to profit by either a rise or a fall in the price of whatever he may be speculating in. Therefore the thing to determine is the speculative line of least resistance at the moment of trading; and what he should wait for is the moment when that line defines itself, because that is his signal to get busy.

Reading the tape merely enables him to see that at 130 the selling had been stronger than the buying and a reaction in the price logically followed. Up to the point where the selling prevailed over the buying, superficial students of the tape may conclude that the price is not going to stop short of 150, and they buy. But after the reaction begins they hold on, or sell out at a small loss, or they go short and talk bearish. But at 120 there is stronger resistance to the decline. The buying prevails over the selling, there is a rally and the shorts cover.

The public is so often whipsawed that one marvels at their persistence in not learning their lesson. Eventually something happens that increases the power of either the upward or the downward force and the point of greatest resistance moves up or clown — that is, the buying at 130 will for the first time be stronger than the selling, or the selling at 120 be stronger than the buying. The price will break through the old barrier or movement-limit and so on. As a rule, there is always a crowd of traders who are short at 120 because it looked so weak, or long at 130 because it looked so strong, and, when the market goes against them they are forced, after a while, either to change their minds and turn or to close out. In either event they help to define even more clearly the price line of least resistance. Thus the intelligent trader who has patiently waited to determine this line will enlist the aid of fundamental trade conditions and also of the force of the trading of that part of the community that happened to guess wrong and must now rectify mistakes. Such corrections tend to push prices along the line of least resistance.

A speculator must concern himself with making money out of the market and not with insisting that the tape must agree with him. Never argue with it or ask it for reasons or explanations. Stock-market post-mortems don’t pay dividends. Not so long ago I was with a party of friends. They got to talking wheat. Some of them were bullish and others bearish. Finally they asked me what I thought. Well, I had been studying the market for some time. I knew they did not want any statistics or analyses of conditions. So I said: “If you want to make some money out of wheat I can tell you how to do it.” They all said they did and I told them, “If you are sure you wish to make money in wheat just you watch it. Wait. The moment it crosses $1.20 buy it and you will get a nice quick play in it!” “Why not buy it now, at $1.14?” one of the party asked. “Because I don’t know yet that it is going up at all.” “Then why buy it at $1.20? It seems a mighty high price.” “Do you wish to gamble blindly in the hope of getting a great big profit or do you wish to speculate intelligently and get a smaller but much more probable profit?”
They all said they wanted the smaller but surer profit, so I said, “Then do as I tell you. If it crosses $1.20 buy.” As I told you, I had watched it a long time. For months it sold between $1.10 and $1.20, getting nowhere in particular.
Well, sir, one day it closed at above $1.I9. I got ready for it. Sure enough the next day it opened at $1.20-1/2, and I bought. It went to $1.21, to $1.22, to $1.23, to $1.25, and I went with it.

Now I couldn’t have told you at the time just what was going on. I didn’t get any explanations about its behavior during the course of the limited fluctuations. I couldn’t tell whether the breaking through the limit would be up through $1.20 or down through $1.10 though I suspected it would be up because there was not enough wheat in the world for a big break in prices.
As a matter of fact, it seems Europe had been buying quietly and a lot of traders had gone short of it at around $1.19. Owing to the European purchases and other causes, a lot of wheat had been taken out of the market, so that finally the big movement got started. The price went beyond the $1.20 mark. That was all the point I had and it was all I needed. I knew that when it crossed $1.20 it would be because the upward movement at last had gathered force to push it over the limit and something had to happen. In other words, by crossing $1.20 the line of least resistance of wheat prices was established. It was a different story then.

I remember that one day was a holiday with us and all our markets were closed. Well, in Winnipeg wheat opened up six cents a bushel. When our market opened on the following day, it also was up six cents a bushel. The price just went along the line of least resistance.

What I have told you gives you the essence of my trading system as based on studying the tape. I merely learn the way prices are most probably going to move. I check up my own trading by additional tests, to determine the psychological moment. I do that by watching the way the price acts after I begin.

Basically in this story something fundamental happened which puts a number of traders on the wrong side of a trade. Traders are short Wheat and once the price goes above the range of known resistance they will gladly cover if the price comes lower, new entrants such as Livermore enter and squeeze those who are short.

The following also illustrates the point, from a book by Stocktwits:

buyer_seller_balance

Also worth studying are Wyckoff concepts:

spring_upthrust

I am a big fan of the Spring and Upthrust. In practice levels do not hold exactly as emotions are involved. You need to give trade some wriggle room and often the best time to enter is when when others are afraid. You have to accept risk and some element of danger. It is hard to get perfect entries and the rapid and computerised nature of the market necessitates that you hold on tight waiting for your trade to work, or not work. You should know when you are wrong and when a trade is not working. You need to be able to do the right thing and get out. This is easier said than done but is key for success – take the losses and keep them small. More about that will be covered in the post about Psychology.

Next posts will be about “Times to trade, Patterns and Reversals”, “Role of Psychology”, “using Volume Analysis in trading”.

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