Support and Resistance

Most experienced traders will be able to tell many stories about how certain price levels tend to prevent traders from pushing the price of an underlying asset in a certain direction. For example, assume that Jim was holding a position in Amazon.com (AMZN) stock between March and November 2006 and that he was expecting the value of the shares to increase. Let’s imagine that Jim notices that the price fails to get above $39 several times over the past several months, even though it has gotten very close to moving above it. In this case, traders would call the price level near $39 a level of resistance. As you can see from the chart below, resistance levels are also regarded as a ceiling because these price levels prevent the market from moving prices upward.


On the other side of the coin, we have price levels that are known as support. This terminology refers to prices on a chart that tend to act as a floor by preventing the price of an asset from being pushed downward. As you can see from the chart below, the ability to identify a level of support can also coincide with a good buying opportunity because this is generally the area where market participants see good value and start to push prices higher again.



The first thing you want to do is change your chart from a line chart to a bar chart. Lines are nice, but they dont give us enough information about what a stock did intraday. A bar chart shows us the open, the daily move and the close (candlesticks also do this, but we will get to those later). Now that you have a bar chart, lets do the most basic of all analysis, lets look for support and resistance levels.



Finding support: Starting from the left in Jan 2005, (first blue arrow), you can see that INTC hit the $22 level, then rallied. In April the stock dropped and hit $22, the rallied again. It seems that $22 is a nice support level. Investors are basically thinking “Hmm, I like INTC and would buy it if it hit $22…” and so they do. If we connect those two support levels and extend the line to the right, it shows us a nice long term support level.

Finding resistance: After that first support was found, the stock rallied, but then stalled at $25.50 in March. You can see that in May, the stock blasted right through that resistance level. Note that support and resistance levels do not have to be horizontal, in fact they can be almost any angle. INTC hit $28 in June, and pulled back, that is another resistance point. By connecting the March and June peaks, then extending the resistance level outward, we find that the next resistance point in July was predicted correctly! Later in November we can see that the old $25.50 resistance stalled the rally, but as soon as it broke through, it moved quickly.

Think of support and resistance levels as jello like barrier, sometimes a stock will bounce off them, other times it will cut through.

Moving Average

Perhaps the most basic of all indicators is the moving average. It is exactly what it sounds like. If your wife spends $100 today, and $110 tomorrow. Her average spending is $105.

Stocks move every day, so if GE (General Electric) closed at $30 yesterday, then at $30.50 today, the average over the past two days is $30.25.

Now lets stretch this out over say… 200 days, we would get a line showing us the average closing price over that time period.

I did not randomly pick 200 days, the 200dma (day moving average) is actually one of the most commonly used indicators. Even those traders or investors who have no clue about technical indicators would know about the 200dma. It is basically the trend line that if a stock is above it, it is doing good, if it is below it, the stock is doing bad. This is obviously an extremely generalized point of view, but it gives us a general frame of reference.

The 200dma is best used with major indices and blue chips, not small or mid cap stocks.




Let us take a look at the 200dma as applied to GE:NYSE. As long as the stock is above the 200dma, it is considered to be in a healthy uptrend. A strong move below the 200dma would indicate some volatility, and if the stock stays below the 200dma for an extended period of time, it is an indication of continued weakness.

The trend of the 200dma itself is important. If the 200dma is uptrending, that tells us the underlying security is in a strong long term uptrend. If the 200dma is downtrending, then the opposite. A stock will often move above and below the 200dma, but as long as it is in an uptrend, its ok.

Short Term Moving Average

If you want to know the long term trends, a 200dma is fine. But what about shorter term moves?

The same concept applies to short term moving averages. Daytraders will use moving averages based on 14dma or even 5dma for general trends, they even get down to 5min and 1min moving averages, but we are not daytrading here.

Let us focus on long term and mid term trends for now.

Instead of a 200dma, lets use a 100dma and also a 50dma. An interesting thing happens when you put two different time frames together, you get two lines that move around each other.




The blue line is a 100dma, you can see how it showing the general trend of the stock. The brown line is a shorter term 50dma, it is more volatile as it more closely follows the actual day to day moves (averaged over 50 days).

Here comes the fun part: See how the 50dma moved above the 100dma Jan 04 (first blue arrow). This indicates to us that the short term trend was extremely stronger to the upside than the longer term 100 day trend. As you can see, the stock did indeed hit some nice highs. You will also note the opposite (red arrow) when the 50dma fell below the 100dma.

Look at July 04, see how the 50dma once again moved above the 100dma? I good indication of short term strength kicking in. GE went from $32 to $37 over the following months. Now look how the trend changed when the 50dma fell below the 100dma in July 05, this indicator told us that weakness is kicking in and GE subsequently dropped from $35 to $33.

Combining Support and Resistance into MA

Believe it or not, after just these three simply lessons you already have the tools for basic technical analysis… very basic though.

Using the same chart of GE, all I am going to do now is identify a recent support level:



As you can see, in the early part of 2005, the $35 area was strong support. We also see some overhead resistance that stopped the rally in May 2005. Now watch how this signal works out, we see the stock break below $35, next we see the 50dma cross under the 100dma. What followed was a continued drop to $33. If you were a trader, you would have exited the stock at $35 and saved yourself that drop.

Not indicated on that chart is that the $33 area is a support level. Can you see why?

You could have used $33 as a re-entry into the stock.

Using RSI and MACD Together

Do not be scared! This is really not that bad!

All I am going to do in lesson 5 is introduce you to two friends of mine, they are basic oscillating indicators, one is called RSI (Relative Strength Index) and the other is MACD (Moving Averge Convergance Divergance).

I have put RSI at the top of the chart, MACD is at the bottom.

RSI

The calculation for RSI is 100-(100/ 1+(U/D)) where U=avg upward price change and D=avg downward price change.

RSI is a oscillator that ranges between 0 and 100. The standard time period that you will find it set at is usually 14 days. Traders will often change this 14d period to make it suit their style of trading. Shorter term for daytrades, longer term (21-50days) for longer term trading.

Simply put, an RSI reading over 70 indicates an overbought situation, below 30 is an oversold situation. Some traders use the peak RSI as a buy or sell signal, others wait for a cross over back below or above the 70 or 30 level to indicate a buy or sell.

This indicator shows you the 'internal strength' of a security. There is also an important divergance signal RSI gives us, which I will cover in a later lesson.

Take a look at this chart. The green arrow shows the RSI touching 30, thats a buy signal. The red arrows show sell signals. You will also note that head n shoulders pattern, combined with the RSI gave a nice sell signal.



MACD

MACD is a momentum indicator that shows the relationship between two moving averages., it is best used in wide swinging trading. MACD is uses crossovers, overbought/oversold conditions, and divergences.

Using the same concept from our moving averages tutorial, when one line crosses above the other, note how the red line crosses the black like at the first green arrow, thats a buy signal. The opposite is true at the red signal.

Important note: No technical indicator is 100% correct. As you become more advanced, you will pick out and combine indicators which suit your trading style.

Important note #2: These are the basics of these indicators, things get increasingly complexed the more you get into it.

Chart Pattern: Triangle

The Triangle is a continuation pattern using the concepts of support and resistance and price breakouts.

The chart below of Amazon.com (AMZN) shows the Triangle continuation pattern:




Generally, when prices make significant moves, they go through a period of resting. Usually with a Triangle pattern, the price consolidation period consists of higher lows and lower lows, forming the shape of a “triangle”. When the resistance and support lines (see: Support & Resistance) begin converging, price will usually burst out of the consolidation area and resume trending in the direction that prices have been moving previously.

Triangle Breakout Buy Signal
The signal to buy is given when the resistance line is penetrated to the upside. The signal is generally stronger if prices have been in an uptrend prior to the upside breakout.

Triangle Breakout Sell Signal
A sell signal occurs when the support line is penetrated to the downside. Usually the sell signal is considered stronger if prices have been in a downtrend prior to the downside breakout.

Two other closely related variants of the Triangle pattern are the Ascending and Descending Triangle pattern; these two patterns are shown on the next page.

Chart Pattern: Head and Shoulders

The Head and Shoulders chart pattern is a heavily used and quite profitable charting pattern, giving easily understood buy and sell signals.

The chart below shows a Head and Shoulders pattern:




Head and Shoulders Components

Left Shoulder: Bulls push prices upwards making new highs; however these new highs are short lived and prices retreat.

Head: Prices don’t retreat for long because bulls make another run, this time succeeding and surpassing the previous high; a bullish sign. Prices retreat again, only to find support yet again.

Right Shoulder: The bulls push higher again, but this time fail to make a higher high. This is very bearish, because bears did not allow the bulls to make a new higher or even an equal high. The bears push prices back to support (Confirmation line); this is a pivotal moment – Will bulls make another push higher or have the bears succeeded in stopping the move higher.

Head and Shoulders Sell Signal
If prices break the confirmation support line, it is clear that the bears are in charge; thus, when price closes below the confirmation line, a strong sell signal is given.
Note that a downward sloping confirmation line is generally seen as a more powerful Head & Shoulders pattern, mainly because a downward sloping confirmation line means that prices are making lower lows.

Reverse Head and Shoulders
The opposite of the Head & Shoulders pattern is the Reverse Head & Shoulders pattern which is another strong pattern, this time a bottoming pattern.




Reverse Head and Shoulders Components
The reasoning behind a Head & Shoulders pattern is as follows:

Left Shoulder: Bears push prices downwards making new lows; however, bulls begin to return and push prices slightly higher.

Head: Price gains don’t last long before bears return and push prices even lower than before; a bearish sign. Prices then find buyers at the new lower prices.

Right Shoulder: The bears push downward again, but this time fail to make a lower low. This is generally seen as bullish sign, bears were unable to push prices further down. Decision time occurs when the price is pushed higher back to support (Confirmation line); either bears will push prices back down or bulls will push prices higher, regaining control of the stock, future, or currency pair.

Reverse Head and Shoulders Buy Signal
When price closes above the confirmation line, a strong buy signal is given.

Usually an upward sloping confirmation line is seen as a more powerful Reverse Head & Shoulders pattern, mainly because an upward sloping confirmation line means that prices are making higher highs.

Volume analysis is important when using the Head & Shoulders chart pattern. How to incorporate volume into the study of the Head & Shoulders pattern is discussed on the next page.

Chart Pattern: Flag

The Flag pattern usually occurs after a significant up or down market move. After a strong move, prices usually need to rest. This resting period usually occurs in the shape of a rectangle, thus the word “flag”. The Flag is considered a continuation pattern because after resting, prices will usually continue in the direction they did before.

The chart shows many Flag patterns:



Flag Buy Signal
When price has moved higher and prices have consolidated, creating a channel of support and resistance, a buy signal is given when prices penetrate and close above the upward resistance line.
Flag Sell Signal
Assuming prices previously moved downward, then after a period of price consolidation, a sell signal is given when price penetrates and closes below the support line.
For more information on the concept of support and resistance, (see: Support & Resistance). Another similar pattern discussed is Triangles (see: Triangles).

Chart Pattern: Double Top

The Double Top technical analysis charting pattern is a common and highly effective price reversal pattern.

The chart below illustrates the Double Top reversal pattern:




Double Top Formation Components

First High: Bulls push prices upwards making new highs; however, these new highs are short lived and prices retreat.

Second High: Prices don’t retreat for long because bulls make another run, making a similar high. Nevertheless, this is bearish, because bulls were unable to push prices higher; bears held their ground at the previous high level. The bears push prices back to support (Confirmation line); this is a pivotal moment – either bulls will make another push higher or bears will take control and push prices even lower, more than likely taking over for good.

Double Top Sell Signal
Sell when price closes below the confirmation line.

Note that traders expect a significant increase in volume to accompany the confirmation line break; if there is very little volume when price pierces the confirmation line, then the move downward is suspect. Small volume usually means weak support of price movement (see: Volume).

Another similar chart pattern is the Head & Shoulders Pattern (see: Head & Shoulders). The opposite of the Double Top is the bullish Double Bottom (see: Double Bottom).

Chart Pattern: Double Buttom

The Double Bottom technical analysis charting pattern is a common and highly effective price reversal pattern.

The chart below illustrates the Double Bottom reversal pattern:



To create a double bottom pattern, price begins in a downtrend, stops, and then reverses trend. However, the reversal to the upside is short-term. Price breaks again to the downside only to stop again and reverse direction upwards. With the second bottom of the double bottom pattern, it is usually more bullish if the second low is higher than the first low.

Double Bottom Buy Signal

The signal to buy is given when the confirmation line is penetrated to the upside. The confirmation line is drawn across the top of the double bottom pattern (see chart above).

Often, after price penetrates the confirmation line, price will retrace for a short time, sometimes back to the confirmation line. This retracement offers a second chance to get into the market long.

Volume also plays an important part of interpreting the Double Bottom pattern; this is illustrated in the chart below of Pfizer (PFE):



Generally, volume should explode when the confirmation line is penetrated as it did in the chart of Pfizer (PFE).

The Double Bottom reversal pattern is a heavily used and effective charting reversal pattern. Another similar and popular bottom reversal pattern is the Reverse Head & Shoulders Pattern (see: Head & Shoulders). The opposite of the Double Bottom is the bearish Double Top pattern (see: Double Top).