Moving averages can provide targets for rallies from deeply oversold levels. Channels or envelopes can provide targets for short-term traders. These tools help catch short-term swings—but such moves seem puny to long-term position traders. We used to call such people investors, before the whole world accelerated and everyone became a trader of one sort or another. Long-term traders, whose time horizon is measured in months or even years, need bigger targets. A deer hunter needs a bigger gun and a different scope than someone who goes out shooting rabbits.
Support and resistance zones provide better targets for long-term trades. We can identify support and resistance by looking for price levels where a great deal of trading has taken place, clearly more than the areas immediately above or below.
In order to have confidence in any technical tool we must understand how it works and what it measures. To put our money on the line, we need to go deeper than merely drawing lines on charts. If we are going to rely on support and resistance, we need to understand the economic or psychological factors they represent.
Each price tick reflects an agreement between a buyer and a seller, but it also represents something greater—the opinion of the crowd that surrounds these two people. Had the crowd disagreed with either the buyer or the seller, someone would have stepped in and snapped away that trade at a different price level.
The more transactions that occur at a certain price level, the more people believe that level represents value. A congestion zone on a chart tells you that many market participants consider that level a fair value and are prepared to buy or sell there.
If you look at any chart, you’ll notice that prices very seldom move in a steady and orderly way for any great length of time. They almost never move in a straight line. Instead, prices stay within a range, swirling behind an obstacle like water behind an earthen dam. Once the dam breaks, the stream of prices surges until it finds another basin. It will now spend a long time filling that basin, until it breaks a new dam and surges again.
If each tick represents a transaction between a buyer and a seller, then a trading range represents a general consensus of value between masses of buyers and sellers. When prices lap at the edges of a range, amateurs become excited. They expect breakouts and buy new highs or sell new lows. Professionals know full well that most breakouts are false and are followed by retracements. They tend to trade in the opposite direction, selling at the upper edges of congestion zones and buying at their lower edges. Once in a blue moon the amateurs win, but in the long run it pays to trade with the pros.
This back-and-forth action of prices draws trading ranges on many charts. A range is a horizontal pattern with fairly clear upper and lower boundaries which identify support and resistance. A price range represents a huge financial and emotional commitment by masses of buyers and sellers. If you glance at the average daily volume inside the range, multiply it by the number of days in that range and then by the average price of the stock during that time, you will immediately realize that a trading range for a single stock can quickly run into billions of dollars.
Support and Resistance
When traders and investors buy and sell, they make an emotional as well as a financial commitment. Their emotions can propel market trends or send them into reversals. The longer a market trades at a certain level, the more people buy and sell. Suppose a stock falls from 80 and trades near 70 for several weeks, until many believe that it has found support and reached its bottom. What happens if heavy selling comes in and shoves that stock down to 60? Smart longs will run fast, banging out at 69 or 68. Others will sit through the entire painful decline. If losers haven’t given up near 60 and are still alive when the market trades back towards 70, their pain will prompt them to jump at a chance to “get out even.” Their selling is likely to cap a rally, at least temporarily. Their painful memories are the reason why the areas that served as support on the way down become resistance on the way up, and vice versa. Regret is another psychological force behind support and resistance. If a stock trades at 80 for a while and then rallies to 95, those who did not buy it near 80 feel as if they missed the train. If that stock sinks back near 80, traders who regret a missed opportunity will return to buy in force. Support and resistance can remain active for months or even years because investors have long memories. When prices return to their old levels, some jump at the opportunity to add to their positions while others see a chance to get out. Whenever you work with a chart, draw support and resistance lines across recent tops and bottoms. Expect a trend to slow down in those areas, and use them to enter positions or take profits. Keep in mind that support and resistance are flexible—they are like a ranch wire fence rather than a glass wall. A glass wall is rigid and shatters when broken, but a herd of bulls can push against a wire fence, shove their muzzles through it, and it will lean but stand. Markets have many false breakouts below support and above resistance, with prices returning into their range after a brief violation. A false upside breakout occurs when the market rises above resistance and sucks in buyers before reversing and falling. A false downside breakout occurs when prices fall below support, attracting more bears just before a rally. False breakouts provide professionals with some of their best trading opportunities. From Trading for a Living by Dr. Alexander Elder, John Wiley & Sons, Inc.,1993
Have you ever noticed that people tend to become a little emotional about money?
Do you think that a crowd with a billion dollars’ worth of commitments might be inclined to act when those commitments are threatened?
Support and resistance are built on two powerful emotions—pain and regret. People who have bought in the range only to see prices drop feel a lot of pain. They are waiting for prices to return so they can “get out even.” Their selling, driven by pain, is likely to put a lid on any advance. People who sold short in the range are also waiting for a pullback. They regret that they did not short even more. Their regret will lead them to sell short when prices return to the level where they shorted, resisting the advance. Pain and regret will put a damper on a rally into a trading range or a decline into that range.
Let us review examples of support and resistance on the charts of some well-known markets: IBM and the Euro.
In 2005 IBM (see Figure 4.21) fell into the $73–$78 zone, spent about three months there, and then erupted into a rally. Half a billion shares were traded in that zone, with an approximate value of $37 billion.
Figure 4.21 IBM, weekly chart
A. Half a billion shares traded at approximately $75—about 37 billion dollars within this range. B. Notice how downspikes of Force Index tend to identify important market bottoms. Can you find two more downspikes on this chart?
You can begin to imagine how much emotion was attached to that huge pool of money! When IBM fell back into that zone a year later, there were enough buyers who regretted that they had missed the boat earlier. They soaked up the supply and pushed IBM back up, up, and away.
How can we set good targets for massive rallies? Looking into IBM’s history on the same chart you can see that in recent years whenever the stock got into the $95–$100 zone, heavy selling drove it down. Think of those poor folks who bought near $100 in 2004. After sweating and suffering through the bear trend, don’t you think they were waiting for IBM to rise back to their purchase price, so that they could “get out even?”
Yet of course, “even” is never really even. Think of the lost interest, the depreciation of money, and the loss of opportunity because the money was tied up in IBM at $100 a share. Think of the psychological burden of sitting on a losing position and not being able to concentrate on better opportunities. The losers are waiting, ready to dump millions of shares when the stock finally returns to their purchase price. If you were one of the smart traders who bought near $75, wouldn’t you expect the rally to stall near the $100 level? That zone of overhead resistance would have been a very sweet level for placing your profit target.
The Euro (Figure 4.22) erupted from the gate soon after its listing in 2001, rising from 85 cents to $1.36 within three years. A severe bearish divergence in 2005, marked by a red arrow on the chart, capped the uptrend and sent prices lower. The Euro found support near the 2004 lows, then dipped below that level, frightening the bulls.
It is important to keep in mind that support and resistance are not made of plate glass. They are more like wire fences, and bulls and bears can push parts of their anatomy through them. As a matter of fact, some of the best buy signals occur after the bears manage to push prices slightly below support. This sets off stops and takes out the weak holders before the bulls resume control and lift prices again. We already discussed the signals from false breakouts in an earlier chapter.
At the right edge of Figure 4.22 we see a bullish divergence. The last bar on the right edge has turned blue. This change of the Impulse system tells us that the bears are slipping and buying is now permitted.
If we go long here, what will be the target for the upmove? It would be rational to expect resistance in the congestion zone of the 2005 top, between 1.3 and 1.35.
Figure 4.22 The Euro, weekly chart
A. Support. C. A bullish divergence. B. A bearish divergence. D. Resistance.
Currencies are notoriously hard to trade since they move nearly 24 hours a day. You may be peacefully asleep in your bed while your competitors halfway across the globe are picking your pockets. You wake up to discover that the price move you’ve expected to see has already occurred. If you are a swing trader, looking to catch price moves that last a few days to a few weeks, you are better off staying away from currencies. Leave them to day-traders and to long-term position traders. These people can benefit from the currencies’ well-established tendency to run in long trends.
To follow up on the chart of the Euro, in Figure 4.23 we see a combination of signals—a bullish divergence of MACD, a false downside breakout, the Impulse system turning blue on the weekly chart. They confirmed each other in area B and generated an especially strong message to buy. The entry into this long trade in the Euro worked out extremely well. The buy signal allowed us to set a reasonable long-term profit target—at the resistance in the trading range of the 2005 top.
After the Euro hit resistance at point C it stalled and went flat for several months. At the same time, the behavior of MACD-Histogram in area C indicated that prices were likely to rise higher. The new MACD-H
Figure 4.23 The Euro, weekly chart, follow-up
A–B. Bullish divergence. C–D. Bearish divergence.
peak C, the highest in over a year, showed that bulls were at a record strength. This meant that the price level associated with this indicator peak was likely to be exceeded.
That’s exactly what happened near the end of 2006 and again in early 2007, but on those occasions MACD-Histogram was giving different messages. Its bearish divergences signaled that the upmoves were nearing their ends.
Looking at support and resistance helps you set reasonable targets for long-term moves. The great value of such long-term targets is that they help you fix your eyes on a remote but reachable goal. This helps you hang on to a long-term move and not get thrown off your horse by the short-term action of prices or indicators or both.
Another benefit of having a long-term target is that it reminds you to sell in a predetermined zone. If you buy low, it would be useful to have a reminder to help you sell high. Many traders become more bullish near the tops, along with the rest of the market crowd. A target tells you when your goal has been reached. It may not be a perfect goal, but it is your target. You have set it, and now it tells you to take profits, go home, take a nice vacation, and look for the next trade.
Psychologically, it is much harder to trade long-term trends than short-term swings. In short-term trading you are active, watching the market every day, ready to adjust your stops and profit targets, add to your position, take partial profits, or exit the trade altogether. Many of us find this feeling of control psychologically satisfying. The emotions tend to be very different in long-term trading. There are weeks and even months when you do nothing. You recognize short-term tops and bottoms but restrain yourself from doing anything, as you wait for your long-term target to be hit. That’s why having a price target is so important—it increases your psychological holding power.
To conclude this chapter on setting profit targets at support and resistance, I will share with you another trade from my diary (see Figure 4.24). It will illustrate techniques, as well as some psychological points. It will show why it is harder to hold a long-term position than a short-term trade. And it will allow us to discuss several important issues relating to the management of a trade, beyond simply setting a profit target.
Figure 4.24 STTSY monthly
My attention was drawn to STTS, since renamed STTSY, during a monthly webinar in November 2004. One of our most active participants at the time was Jackie Patterson, a Californian who had left her job to become a full-time trader. She was a good stock-picker, but no stock she brought up had gotten me as excited as STTSY. This computer-chip testing company traded above $60 in the happy days of the 1990s bull market but fell below $6 during the bear market. It was one of those “fallen angels” we have already discussed. The idea, of course, is to buy after a stock stops declining. It is OK to buy cheap but not OK to buy on the way down. The weekly chart appeared extremely attractive. It showed that after the stock crashed from above $60 to below $6, it bounced above $17. Another fall, below $5, was followed by a bounce to nearly $16. This puppy’s behavior made it clear that even after it lost over 90% of its value it had no desire to die. A stock that has survived a bear market becomes a prime buying candidate for the next bull market.
Figure 4.25 STTSY weekly
At the right edge of the chart STTSY fell again, below $6. The price level below $6 emerged as a very strong support zone. In looking at the chart, it became evident that the zone near $16 provided very strong resistance. Whenever STTSY rose to that level, it seemed to hit a ceiling and come tumbling back down to the floor.
Zooming into the right edge of the weekly chart (Figure 4.25), the picture became even more attractive. The stock established three lows during the past six months at $5.50, $5.40, and $5.37. This pattern told me several things. First of all, the support was solid. Even when the stock was pushed to a slightly lower low, it refused to accelerate to the downside, but instead recoiled and came back up. Furthermore, the fact that STTSY kept stabbing to lower lows looked tremendously bullish to me. Those quick stabs seemed to indicate that some powerful interests were trying to push the stock a little lower in order to frighten holders into selling so they could buy up their shares. David Weis, a very experienced trader, jokingly called such interpretations “a paranoid view of the markets.”
The bears were so weak that MACD-Histogram stayed above zero during the latest decline. Force Index, in the bottom pane of the chart, showed three stabs to the downside—each more shallow than the
When the Impulse system went blue at the right edge of the chart, it removed the last prohibition against buying. I bought 10,000 shares at $5.99. My plan was to hold until STTSY reached $16, which I figured might take a couple of years. I was looking to clear a $100,000 profit on this trade.
As the stock began to move in my favor, I added another 5,000 shares at $6.13, but a few weeks later offloaded that lot at $6.75, clearing 62 cents and booking a quick profit on that side bet. My plan was to hold for the long haul, but this turned out to be much more stressful than quickly trading in and out.
STTSY briskly rallied to $8.16, then sold off back to my buying point. I was convinced that my initial plan was correct and continued to hold. STTSY rallied again, this time to $8.85. I saw multiple signals of a top, including a bearish divergence of weekly Force Index, marked with a red arrow on the chart (Figure 4.26). Focusing on my target of $16, I clenched my teeth and held. The decline quickly wiped out nearly $30,000 of paper profit and the position briefly went negative as STTSY dipped below my entry point. I held on to my original plan, focusing on the bullish details, such as a “kangaroo tail”—a one-bar stab towards the lows. It was accompanied by a bullish divergence of Force Index, marked with a green arrow on the chart.
Figure 4.26 STTSY weekly
STTSY rallied again, this time up to $8.42, but holding long-term was becoming less and less fun.
During this trade I made a multitude of shorter-term swing trades in other stocks. Trading short-term was a lot more fun and profitable. I also held a handful of other long-term positions, similar to STTSY, as my plan was to teach myself to hold for the long haul. Still, my position in STTSY was starting to feel like a headache. I’d had enough of those rallies into the $8–$9 zone, followed by declines back down to the purchase point, with no profit to show for my work or patience.
In February 2007, two years after I bought STTSY, the stock rallied to $8.65, slightly better than its previous high of $8.42. There the rally stalled and the weekly ranges became narrow. Such signs often precede price declines. I felt the weight of STTSY on my shoulders and gave an order to sell, getting out of my 10,000 shares at $8.39. Instead of hitting my $100,000 target, I cleared less than $24,000 on this trade— $27,000, taking into account a side bet on STTSY early in the game. I was happy to be out of STTSY, liberated from having to look at the stock as it gyrated up and down. Still, I had gotten into such a habit of watching it that I kept an eye on it (see Figure 4.27). What I saw turned out to be highly amusing, to say the least.
Figure 4.27 STTSY weekly, follow-up
Just a few days after I got relief from selling STTSY, the stock stood on its hind legs and roared. Two weeks later it traded near $12. Most indicators confirmed the great strength of the bulls by reaching new record highs. They signaled that whatever brief weakness may intervene, the bulls were very strong and that $12 was likely not the final peak in STTSY. The stock appeared ready to go higher, and the initial target of $16 looked very realistic.
Did I buy it back? Of course not! My two-year entanglement with STTSY was over. The relatively small profit I took out of its ongoing spectacular move would be the only money I’d make out of it—much less than what was available. So why show this trade here? Is there anything we can learn from it? Yes, quite a lot. Here are the lessons, in no particular order:
1. As we said earlier, whenever you put on a trade, you have two goals: to make money and to become a better trader. You may or may not reach the first goal, but you must reach the second. If you do not learn from your trades, you are wasting your time and money. During this trade, I kept good notes, both in a spreadsheet and in a visual format in my diary, allowing me to extract lessons from the experience. The money profit was relatively small, but the trading lessons were multiple and rich.
2. First of all, my entry into this trade was excellent. I had correctly identified an important bottom and acted in good time. Second, my profit target for the trade appears to have been on track even though I could not hold long enough to get full benefit from my analysis.
3. This trade confirmed to me that I am temperamentally better suited for shorter-term trading. Since I am determined to learn to hold long-term, I must adapt by adding some elements of short-term trading to my long-term positions. I decided that in future long-term trades I will establish a core position that I will hold from start to finish—its smaller size will produce less stress. At the same time, I will put on larger short-term trades in the direction of my long-term trade. Looking back on Figure 4.26, there would have been every reason to buy extra on the way up, sell when tops were formed at the upper dashed line, and buy again whenever the stock fell back to its original buy zone near the lower dashed line.
4. This trade reminds us that it is important to treat yourself well. Your mind is a trading instrument, and abusing yourself for mistakes, such as getting out too early, would be like slapping your computer—it does not improve performance. My goal is to learn from my mistakes, not to punish myself for them.
5. Last but not least, I want you to see that even experts make mistakes. I still make them. You will continue to make them. The idea is to weed out gross mistakes, such as not using a diary or violating money management rules. Once you’ve done that, you can concentrate on the lesser ones.
As I write this book, I have several long-term trades going. There is a major U.S. industrial concern whose stock, I believe, wants to rise from $7 into the $20+ range. I am even more excited about a little Nasdaq number that trades for a bit over a dollar. It traded near $100 in the 1990s—this fallen angel lost over 99% of its value in recent years. I acquired the bulk of my position below $1 and expect to hold it until the stock reaches $20 a couple of years from now. With both stocks, I have a core position that I do not touch and a bigger short-term position that I keep putting on and taking off, actively trading in the direction of the trend. The lessons of STTSY are continuing to help me.
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