Support& ResistanceTHE CMC MarkETs Trading sMarT sEriEs January 2013

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Primary Indicators — the key to profitable trading

Trend recognition is a critical factor in the success of any trading plan. Many investing strategies seek to profit from trending markets. The idea is to enter the market when a new trend starts and to hold your position open until there’s an indication that the trend is ending.

Technical analysts use a set of tools to assist them with this process. Some tools tell you what the current trend is, others can be useful in helping you to decide if the current trend is about to change. These tools include price patterns as well as indicators and studies. To use these effectively, however, you first need to understand what a trend is.

What exactly is a trend? A trend is simply the general direction in which price is tending to move. Technical analysis uses a stricter definition. It’s easy enough to see

what the general direction of price has been when you look back at the price history, but it’s not so easy to understand how it affects the

current situation. Applying a strict definition helps with this.

An uptrend

An uptrend is when price follows a succession of higher highs (or peaks) and higher lows (or troughs). See figure 3.1 for a theoretical

representation. An uptrend is considered to be intact as long as the price dips against the uptrend stop at higher levels than previous dips.

Figure 3.3 shows a practical example of this, where the uptrend is showing a steady progression of higher highs and higher lows. At the end

of the chart it can be concluded, technically, that the uptrend is intact.

Figure 3.1 - Peaks and troughs in an uptrend

A downtrend

A downtrend is occurring when price follows a succession of lower highs (or peaks) and lower lows (or troughs). See figure 3.2 for a

theoretical representation. A downtrend is considered to be intact as long as the price rallies (rises) against the prevailing downtrend stop at

lower levels than previous rises, as shown in figure 3.2.

The chart in figure 3.4 shows a downtrend market and an uptrend market, in sequence. No trend lasts forever, and a different approach

must be used if market price action suggests that the trend is changing.

Figure 3.2 - Peaks and troughs in a downtrend

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Figure 3.2 - Peaks and troughs in a downtrend

Figure 3.3 – An uptrend

Support and resistance The troughs and peaks of trendlines are also known as support and resistance levels, respectively. The identification of these levels

represents one of the most important skills in technical analysis.

Support, as the name implies, indicates a price level or area on the chart under the current market price where buying interest is sufficiently

strong enough to overcome selling pressure. As a result, a decline in price is halted and prices are turned back up again.

Resistance is the opposite of support. It represents a price level or area above the current market price where selling pressure is likely to

overcome buying pressure, causing price to turn back down against an uptrend. It should be emphasised that an existing prior high does not

imply that subsequent rallies will definitely fail at or below that high with pin-point accuracy, but rather that resistance can be anticipated in

the general area.

Figure 4.1 - Support and resistance in an uptrend

Practical rules for finding support and resistance

Finding support and resistance involves determining what critical prices define the trend (or range) and are more important over and above

other prices. There are guides and rules for determining the legitimacy and strength of a price level, irrespective of whether it is a support or

resistance. These include:

Times tested — where a price level has been ‘tested’ (traded) at or near, several times, it tends to be remembered by participants. For

example, traders would tend not to sell into a low or trough if past experience has shown this is not wise.

Volume spent — following on from the above point, if large amounts of volume have been transacted at or near a certain level, this also

tends to be considered and noted by participants in the market.

Recent trading —the more recent the trading at a certain level, the more relevant the level is to an analysis of market price.

Round numbers — for reasons more to do with psychology than anything else, traders (and people in general) tend to remember ‘round

numbers’.

Some examples of support and resistance can be seen in figure 4.3.

Figure 3.4 - downtrend with reversal then on-going uptrend

Figure 4.2 - support and resistance in a downtrend

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Figure 4.3 - Support and resistance levels

Trading strategies using support and resistance

One of the best uses of support and resistance is for entry and exit of positions coupled with efficient risk management setting.

Some of the practical uses include:

• Take profit. This is the price at which one takes the profit available on a position. That is, as the price approaches a support (from

above), short sellers should take profits on their positions. Conversely, as price approaches a resistance (from below), long traders

should take profits.

• Establish a new position near an unbroken level. When the price approaches the support level, a technically driven investor

would tend to pitch limit buy orders near and above a defined support and, conversely, would pitch limit sell orders near and just

under resistance levels.

• Establish a new position on a break of a level. When a support breaks, one can initiate a short position,on the technical

expectation that prices will then go onto the next (lower) support level. Conversely, if a resistance breaks, one should buy in the

expectation that prices will move on to the next (higher) resistance, if there is one.

• Stop loss setting. A breach of a level can be used to limit loss too. Rather than using a break of a support or resistance level as an

opportunity to establish a new position, you can also use it to minimise loss. A losing position should be immediately exited. The

signal to do so comes from the breach of the support or resistance level.

Once broken, support and resistance levels reverse roles. This is a key aspect of support and resistance identification: once a level (whether

support or resistance) is broken, the technical characteristic of the level is reversed. That is, a broken support now becomes a resistance and

a broken resistance now becomes a support. This can be seen in figure 4.4.

Figure 4.4 - Resistance reversal

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Technical analysis in ranges One of the most useful technical patterns is a sideways trend, or range. It allows a simple, mechanical strategy to be followed as detailed

below.

Figure 5.1 - An example of a generic ‘range’ price pattern

The first step is to identify the support and resistance that bound the current and recently observed price action.

Once this is done, pitch the buy and sell orders appropriately, near and above the support and near and just under resistance levels

respectively.

After this is done, it is prudent practice to apply stop losses (i.e. exit orders) to the buy (or sell) orders.

An example:

A basic example of a trade plan, with a planned limited risk (i.e. the difference between our orders and the exit), for a hoped for return. There

are two possible scenarios that may follow on from this plan.

If the trade plan outlined in figure 5.2 is used and a sell position is entered into, one of two events will occur. They are outlined in figure 5.3

and 5.4.

Figure 5.3 shows the ideal scenario. A short (sell) position was entered into at the top of the range, near the high and resistance level, with a

stop loss on the other side of resistance.

From the selling point, the price falls back to the lower end of the range and the take profit order (near support) is triggered and the position

is exited with a profit.

Figure 5.4 shows the scenario to avoid, but that you must be prepared for. A short (sell) position was entered at the top of the range, near

the high and resistance level, with a stop loss on the other side of resistance. From the selling point, the price rises back to, and through, the

upper end of the range, instead of falling. In doing so, it hits and triggers the stop loss. This position is therefore exited with a loss.

Note: Please be aware that this is a very basic outline of a possible trading plan. You should never stop learning and practicing in this area.

Figure 5.2

Figure 5.4 - What happens if the price goes up when you had short sold

Figure 5.3 - What happens if the price goes down

when you had short sold

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This is a theoretical example of a trade plan, driven by:

1) Identification of support and resistance

2) the application of buy and sell orders based on point 1), and

3) the application of stop loss measures to limit risk and safeguard performance.

Here is a schematic method shown in figures 5.3 and 5.4, applied to a practical (but historic) trading plan and market.

Sketching out the plan, a practical example:

In this example a support has been broken and the price has dropped much lower. Over time the price action has recovered to just below the

old support, which is now expected to have reversed, to become a resistance level.

There are two options. The first is to short sell just below the resistance with a stop loss on the other side anticipating a drop in price. The

second is to wait to see if there could be a technical breakout (where the price breaks the resistance) and a buy order can be entered just

above the breach with a stop loss slightly below the old resistance (now expected to act as support).

Figure 5.5 – First option: sell short after the breakdown with stop loss set just above old support

Some additional key patterns to look for

The pattern in figure 5.6 is known as a ‘double top’. It is a range pattern, where there are two distinct tests of resistance, which are then

followed by a fall in price back down to the support level of the defined range, which is then breached. Note that the name of the pattern is

not as important as the fact that a key identified level (in this case a support) was cut, or breached.

There are elaborations of such patterns. If, for instance, there were three distinct tests of the topside (or resistance), followed by a price fall

that actually breaks the support of the range, this would be called a ‘triple top’.

Figure 5.6 - The double top

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A pattern is ‘confirmed’ once the support or resistance levels are broken. Otherwise it is only a probable or provisional pattern.

Figure 5.8 – A double bottom

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