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.

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.

Enjoy!

1.  SUPPORT AND RESISTANCE DEFINED  
2.  SUPPORT AND RESISTANCE DURING THE KLA-TENCOR (KLAC) DOWNTREND  
3.  TREND: THRUST, CONSOLIDATION, COUNTERTREND MOVEMENT  
4.  SUPPORT, WHEN BROKEN, BECOMES RESISTANCE  
5.  KEY SOURCES OF "SIMPLE" SUPPORT AND RESISTANCE  

6.  SUPPORT AND RESISTANCE IN THE UPTREND  
7.  "SIGNIFICANT" SUPPORT AND RESISTANCE  
8.  THE "ALTERNATION" PRINCIPLE  
9.  THE PSYCHOLOGICAL BASIS OF THE ALTERNATION PRINCIPLE  
10.  EXAMPLE OF "PRICE PATTERNS"  
11.  CONCLUSION  

(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:

• R1-S2. KLAC trends sharply downward. It finds support in early August at $35, where it then moves sideways, or "consolidates," for several days.
• S2-R2. The shares rally briefly from roughly $35 to $40. Notice how we can connect R2 with S1 by using a straight line. What had been for a short time a support level has now turned into a resistance level.
• R2-S3. Between mid-August and early September the shares drop precipitously, from $40 to $30.
• S3-R3. The rally is brief. KLAC recovers to $35. What had been support at S2, $35, has now turned into resistance at R3.
• R3-S4. A mid-September decline takes KLAC from $35 to $27.
• S4-R4. KLAC pushes back to $30, the level at which it had previously found support (at S3).
• R4-S5. The shares decline to their final early October low of just over $25.

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.)

1. Simple support and resistance often occur at round numbers. For KLAC this took place at each $5 interval between $25 and $45. For stocks under $10 each dollar increment seems to present round-number support and resistance, with $5 and $10 being particularly potent prices. When you analyze a stock, always check to see the round number prices it is finding support and resistance at.
   
   
2. A support level, once broken, is highly likely to become new resistance. For example, KLAC had support at $40 at S1. The next rally back to this level at R2 failed. Five months later, at R6, the rally also stalled at this price point.
   
   
3. A resistance level, once broken, is likely to become new support. Note how KLAC stalled twice at $35 at R3 and R5. When it finally overcame R5, the shares twice found support or buying interest at this level (at S7 and S8).
   
   
4. You can usually define support and resistance by drawing horizontal lines on the chart. There are, however, several other sources of buying power and selling pressure. For example, an uptrend line often represents a moving support point. Note how an uptrend was confirmed by KLAC touching the line three times at S7. Had you purchased within the next several days as KLAC came close to -- but did not break -- the uptrend line, then you could have racked up substantial trading gains simply by purchasing at trendline support. Interestingly enough, a broken trendline can also serve as support or resistance. You can see this occur on the KLAC chart at S6.
   
   
5. A moving average can be thought of as a curved trendline. Note how the 20-period moving average (the dashed line) provided resistance during the downtrend by being above falling prices. Similarly, when the trend reversed it provided support to the uptrend by being below rising prices.
   
   
6. The bottom or top end of a Bollinger band can also serve as a support and resistance level. The swing trader should be careful, however, not to use this idea mechanically, as a stock's price can sometimes "ride" or "climb" the band.

(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.

Good trading!

Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader

Income Security of the Month If you're looking for high yields, monthly payments and unprecedented safety from your investments, then you need to learn more about our "Income Security of the Month" for November 2008. This stable preferred stock has a long track record of paying some of the most solid dividends in Wall Street history. In fact, the preferred issue pays a monthly dividend totaling 10.3% annually and has outperformed the S&P 500 by more than +44 percentage points over the last year!

Top 10 Stocks for 2008! Since we began publishing this report back in 2003, the picks we've featured have consistently beaten the broader market -- delivering average gains of +21.3% per year and outperforming the S&P by a nearly 2-to-1 margin. Act now to reserve your copy of our newest report -- Top Ten Stocks for 2008.