Lesson
#3 -- A Swing Trader's Support and Resistance Secrets In our last trading lesson I did my best to acquaint you with trends and trendlines. I started by showing how the simple labeling of peaks and valleys could help you determine if a stock was in an uptrend or a downtrend. Recognizing the trend of the stock, you saw, was the key to profitable swing trading. I then introduced you to a few simple rules one should follow when drawing the trendline. These are rules I use every time I draw a trendline on a chart and they are vital for keeping me on both the right side of the market and on the right side of any given trade. Along with this, I taught you the importance of not fighting the trend. One of the most profitable swing trading strategies I know of involves buying on the break of the downtrend line and taking profits on the break of the uptrend line. Finally, for those interested in more practice, I challenged you to analyze a historical chart of KLA-Tencor (KLAC) to gain practice with drawing trendlines. I will present you with my interpretation of those trendlines at the end of today's trading lesson. The KLAC chart will also serve as our focus for today's discussion of support and resistance. Although the KLAC chart below covers almost the same period as the one I used for trendlines, I have made some minor adjustments such as adding moving averages, reducing the number of indicators and enlarging the chart size.
Instead of labeling the chart with "P" for peak and "V" for valley, I have now marked the key highs and lows with "S" for support and "R" for resistance. The chart covers approximately nine months of KLAC trading history. Please note that I've numbered the support and resistance points from R1 to R9 and S1 to S10. The discussion of support and resistance in today's trading lesson of necessity contains an extremely detailed analysis of KLAC's chart. It is almost imperative that you print out today's trading lesson to gain the maximum benefit from it. To fully appreciate how you can profit from careful
identification of support and resistance levels, you will want to frequently
compare the following text with the KLAC chart throughout today's lesson. 1. SUPPORT AND RESISTANCE DEFINED (1.) SUPPORT AND RESISTANCE DEFINED The ideas of trend and support/resistance are very closely connected. During a prolonged trend, prices often go through some periods of strong buying interest (support), and other periods when selling outstrips buying (resistance). Support may be defined as any price point below the current market price where buying should emerge to create, at least temporarily, a pause in a downtrend. Resistance, on the other hand, is any price above the current market price where selling should emerge to create, at least temporarily, a pause in an uptrend. A chart can be thought of as a picture of the war between supply and demand. At a support level, we expect the buyers to win the war -- for the time being. The opposite is true at resistance. Eventually, however, the conflict is resolved, support and resistance levels are overcome and the dominant trend reasserts itself. If the stock is in a downtrend, then the support level is usually taken out. If in an uptrend, then the area of resistance is typically broken. (2.) SUPPORT AND RESISTANCE IN THE KLA-TENCOR (KLAC) DOWNTREND Please refer to the KLAC chart above. For starters, note that when this particular time period began, the stock was in a long-term downtrend. (That's relatively easy to see on the chart by examining the relation of the stock's price to the long-term 150-day or 200-day moving averages.) The first point I want to draw your attention to is in July. I have labeled this "S1" on the chart. Note how the overall downtrend was arrested for several days, right around $40, as the buyers temporarily overwhelmed the sellers. In fact, buying demand was strong enough to push the stock back above $45, where it subsequently faltered. I have labeled the point of faltering, where supply overcame demand, as "R1," a level of resistance. Note that S1 and R1 occur very close to the "round" numbers of $40 and $45. This is a point we will return to later in today's lesson, and it is a very important concept to take into account when you swing trade. Now let's follow the stock as it declines:
Shortly, I will analyze the uptrend, which started at S5. Before I get into that, however, let's summarize what we can about support and resistance by analyzing the downtrend. A number of the concepts presented below are seldom discussed explicitly in technical analysis literature, yet they are extremely important for you to master if you want to swing trade with maximum profitability. (3.) TREND: THRUST, CONSOLIDATION, COUNTERTREND MOVEMENT The July to October period captures KLAC in a strong downtrend. From approximately $45, KLAC declined to just over $25 in about four months. We can subdivide this overall downtrend into segments that I will call "cells." (This is my own term, so don't be alarmed if you have not have seen it before.) R1-S2-R2 is an example of a cell. The next cell is R2-S3-R3. The final cell in the downtrend is R3-S4-R4. (In the following cell -- R4-S5-R5 -- the trend then reverses.) Within each cell you can spot three different types of price movement. I have called these "Thrust," "Consolidation" and "Countertrend Movement." Each cell begins with a period of thrust. The order of consolidation or countertrend action that occurs after the thrust often varies. Again, I call the first period of a given cell "Thrust." It is a time of very strong trending action and can be identified on the KLAC chart, for example, between R1 and S2. During that time period the price went from $45 to $35 in just a few trading days. After KLAC reached $35 in very early August, the shares moved sideways for about 10 trading days. This was a time of "consolidation," or "trendless," sideways movement. The cell ended with a period of countertrend rally when KLAC climbed from $35 to $40 in three trading days. I have labeled this retracement to $40, which represented the peak of the countertrend movement, as "R2" on the chart above. Not accidentally, this countertrend rally halted at almost the exact level as the S1 broken support. Carefully follow any of the "cells" in either the uptrend or downtrend and you will find that thrust, consolidation and countertrend movement comprise them all. This concept can help you as a swing trader by providing you with a roadmap to the price action and a guideline for trading strategy. For instance, when KLAC retraced from S2 to R2 and then stalled, you could have initiated a short position. If you were more cautious and wanted more certainty that the countertrend rally would fail, then you could have waited for KLAC to break below S2 at $35. At that point you could then have gone short. Even from $35, you'll note that the shares declined to $30 in just five trading days -- a swing that could have yielded the alert trader a 14% profit in just one week! You could have again entered a short position at R3. The gravestone doji candlestick occurring at resistance was a strong signal that the countertrend rally of this cell had ended. Again, if you wanted more safety and more evidence, then you could have waited until KLAC broke below S3 at $30. A short here would have still returned about $4 per share, or 13%, in just six trading days (although you would have needed to be alert to avoid the rapid reversal). (4.) SUPPORT, WHEN BROKEN, BECOMES RESISTANCE Another point of vital interest to swing traders is that the support level of the prior cell, when broken, is likely to serve as the resistance level of the following cell. You can easily observe this pattern several times in the KLAC chart. For example, when the stock broke $40 support in late July (at S1), on the next countertrend rally this same level became resistance at R2. When $35 was pierced at S2, it then became resistance at R3. When $30 was penetrated at S3, it became resistance at R4. The swing trader can use this observation very profitably by identifying a downtrend and then shorting either at the peak of resistance or when the stock has broken the previous support level. This key idea is even more important when a support or resistance level that has been tested many times over several weeks or months -- instead of just briefly -- is broken. I will discuss this idea in greater detail below under the heading, "The Alternation Principle." (5.) KEY SOURCES OF "SIMPLE" SUPPORT AND RESISTANCE From this detailed study of the KLAC chart, we may generalize by saying there are SIX sources of simple resistance that the swing trader may use to analyze a chart and find highly profitable trading opportunities. "Simple" support or resistance occurs when a price level is touched for a few days. (Note that I always distinguish between that and "significant" support or resistance, which is a price level returned to over and over again.)
(6.) SUPPORT AND RESISTANCE IN THE UPTREND A change in visual pattern in early October should have put the vigilant swing trader on the alert that a significant shift in KLAC was taking place and that the stock should no longer be traded short. Note the very important change at this time. R4 should have served as the first level of resistance to KLAC. This pattern had held for the previous four months, yet it didn't hold during the mid-October rally between S5 and R5. Instead, the stock blew through $30, breaking the downtrend line. After a very brief countertrend retracement at $35, KLAC then soared to resistance at $40 at R6. At that point, the observant swing trader should have been full aware that for a period of time the downtrend had reversed and that KLAC had begun an uptrend, which is defined as a series of higher peaks and higher valleys, or higher levels of resistance and support. Note that the pullback at S7 was at a higher level than at S6. KLAC then had a final recovery peak at $45 at R7 in late November. Shortly after R7, the uptrend line broke. Again, the pattern of lower highs and lower lows, and of lower levels of resistance and support, resumed. Except by those swing traders with an extremely short time frame, say one or two days, the stock should not have been traded from the long side after that point. (7.) "SIGNIFICANT" SUPPORT AND RESISTANCE As you have just seen, "simple" support and resistance can come about in six major ways. Each of these ways can help you execute profitable swing trades. However, what I call "significant" support and "significant" resistance are perhaps the most important and profitable of all to recognize. Whereas a simple support or resistance level may only be touched for a few days (see R1 for example), a significant support or resistance level is one which is tested many, many times. KLAC offers a very good example of significant support and resistance in the early November to February period. The key price level here is $35. Notice how the rally off the October lows swiftly brought KLAC to $40. The pullback in mid-November at S7 saw the shares revisit $35. From here a rally took them to a recovery high at R7. The pullback then took them back to $35 at S8. A rally in the early part of January saw KLAC climb to $43, but again the shares pulled back. At S9, the shares hovered around the significant support level at $35. When KLAC finally broke $35, the stock fell rapidly, declining to about $31 in just two trading days. If you can successfully recognize the break of "significant support," then you'll usually find yourself a very high-probability trading opportunity. When trading such a chart pattern, you'll usually want to set a stop just above the significant support level. This is due to the "Alternation Principle," which I will describe in detail below. In the KLAC example, to be very safe you might have wanted to set a stop at, say, $36.50. So if you had shorted at $35 in late January, then your maximum loss would have been just -4.3%. If KLAC runs true to form and you cover your short at $30, then your gain will be +14.3%. Nice odds! The KLAC chart also illustrates significant resistance. Notice how after KLAC broke $40 in early July it then tested this price level four separate times (late July, mid-August, early November and mid-November) before penetrating it. And when it finally did, KLAC then raced $5 higher in just six trading days. A swing trader who bought on the break of significant resistance would have achieved a +12.5% return in short order. Again, this is a high-probability trade in which you would have been able to set a very tight stop. (8.) THE ALTERNATION PRINCIPLE What I call the "alternation principle" is one of the most important and profitable of all technical analysis guidelines. It states that when a significant support level is broken, that level, if and when retested, should serve as new resistance. Similarly, if a resistance level is broken, then that level, if and when retested, should serve as new support. In my experience the alternation principle works approximately 85% of the time. Even when it doesn't, it at the very least gives the swing trader significant information about the strength or weakness of the stock. (9.) THE PSYCHOLOGICAL BASIS OF THE ALTERNATION PRINCIPLE Here's a riddle. What is the most important price on the price chart? Answer: It's the one you paid. This simple idea has important psychological implications. Let's say you bought KLAC at $40 in early July (S1). Immediately, the shares rise to $45. Not only is the transaction profitable, but it also confirms your feelings of self-esteem: you have made a good trading decision. However, let's say you choose not to take your profit. By mid-August (S2) you not only have forfeited all your profit, but KLAC is actually down to $35 and you are now stuck with an unrealized capital loss. Now the shares rally back to just above $40 at R2. Will you choose to sell? You now have a chance to get out at breakeven, or perhaps with a profit of 25 or 50 cents a share. Psychologically speaking, at this point a breakeven trade may feel like a gift from the stock market gods! Multiple this behavior by all the thousands of traders in the stock and you can see why a support level, when broken, becomes new resistance and is apt to turn prices back when retested. Similarly, let's say you have been watching KLAC trade strongly off its October bottom. You think it will hit resistance at $35, but instead it blows right through that level and goes to $40 at R6. You don't want to chase the stock and don't buy. Finally, it comes back to $35 at S7 and seems to hold. At that point you might seize your opportunity to buy at a "bargain" price. (10.) EXAMPLES OF "PRICE PATTERNS" Price patterns go back to the work of Schabaker in the 1920s. Edwards and Magee then built on those ideas in the 1930s. The idea of price patterns is that they repeat themselves over and over again throughout time. If you can recognize the price pattern and accurately predict it, then you're likely to make substantial swing trading profits. I use price patterns to create profitable swing trades every week when I write my STREETAUTHORITY SWING TRADER newsletter. In addition, I frequently cover price patterns in the final section of every weekly newsletter -- "Inside The Black Box." The vast majority of price patterns are formed by combining a trendline with a support or resistance level. Two of the most important price patterns to recognize are the ascending triangle and the descending triangle. The ascending triangle is made up of a horizontal level of resistance and an uptrend line. In a bull market, it is often safe to play the ascending triangle before the breakout since prices are likely to leave a price formation in the same direction as they entered. In a weak market, the swing trader should generally wait for a convincing breakout before going long. You'll want to see stronger-than-normal volume on the breakout, as that will indicate the buyers are more anxious to acquire the stock than the sellers are to part with it. The historical chart of Amgen (AMGN) below provides us with a great example of an ascending triangle formed during a very weak period for the S&P 500. These types of stocks are often worth following closely because when the market does turn higher, they then become the new leaders.
The opposite of the ascending triangle is the descending triangle, which is formed by a downtrend line and a horizontal support line. You can frequently find this price pattern in bear markets. The historical charts of Clear Channel Communications (CCU) below clearly illustrate this pattern. (FYI -- I recommended this stock as a successful short candidate in my weekly STREETAUTHORITY SWING TRADER newsletter in February, 2003 -- around the time of this chart.)
Trendlines and support/resistance levels are perhaps the two most important tools one can use when analyzing a chart. Over the course of the last two trading lessons I have described both of these concepts for you in great detail. They should not only provide you with a strong foundation in technical analysis, but should also help you improve your own ability to find and execute profitable trades. In each issue of the STREETAUTHORITY SWING TRADER I use trendlines and support/resistance levels to spot potentially profitable trading opportunities. In addition to these general concepts, you learned several specific principles of using support and resistance to initiate profitable trades. You can, for instance, sell short during a downtrend when a stock penetrates a simple or significant support level. Meanwhile, during an uptrend you can go long when a stock penetrates a simple or significant resistance level. These are often high-probability trades, particularly when you take into account the other technical indicators on the chart. In our next trading lesson I will cover a tool that I find absolutely vital for swing trading success -- Japanese Candlesticks. Candlesticks are important because they often send out an early warning signal when a trend is about to change. Think of them as a sentry alerting you to an impending bullish or bearish counterattack. They can help you protect a profit or initiate a short position. Some traders use candles as an entire system in and of themselves. However, my style is to combine them with other technical analysis tools such as trendlines, support and resistance and momentum divergence. This use of "multiple indicators" -- where the decision to go short or buy long is based on many confirming messages on any given chart -- is what provides me with high-probability trades. Candlesticks are an important topic that I discuss again and again in my STREETAUTHORITY SWING TRADER newsletter. But what if I told you that if you recognized five -- yes, that's right, only FIVE candlesticks -- you would have been able to call every major reversal in the S&P 500 for a six-month period. Curious? If so, then I'd urge you to join me for the next trading lesson in which I discuss "Swing Trading by Candlelight." Before I conclude, I'd like to present you with the "answer" to the question I posed at the end of our last trading lesson. You'll find my interpretation of the trendlines on the KLAC chart below. If your lines agree with mine, great! However, be aware that if they don't, then you are not necessarily wrong. A trendline is merely an interpretation of a stock chart, and there are times when different interpretations are defensible. Also, if you are new to trendlines, then you will find that the more you draw them, the more confident you will become. I'll help you along the way by drawing trendlines on all charts I analyze in the STREETAUTHORITY SWING TRADER.
If you enjoyed the challenge I presented you with above, then perhaps you're ready for another! The stock I've chosen is Harrah's Entertainment (HET). Instead of merely having you draw trendlines, this time I'd like to see you do three things based on the information you've gathered from the last two trading lessons:
Good trading in the coming weeks!
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