Support and Resistance

Support and resistance refers to price levels at which a market will have difficulty penetrating. A support area refers to a level at which the market finds plenty of buying interest and can't break to the downside. Conversely, a resistance point is where the market has trouble rallying past and selling interest keeps it in check. Once a market has found a level at which it cannot penetrate and turns away from it, it is difficult to come back and take out that level. If it does, it typically will have renewed energy in the new direction and will unlikely go back into its old formation.

As mentioned before, the function of a marketplace is to be always searching for an equilibrium price. When a high gets established in a market, it means that there simply was no more buying power to push it up one more tick. When a low is established, it means that all of the selling was done and the market found a value area at which buyers were willing to come in and take ownership. These highs and lows are the extremes that a market has found that has made it turn around. They can be the boundaries of short or long term trading ranges. They can be the ends of minor or major swing moves in a trending market, or gap areas, or any place where the market has reached a turning point. Identifying particular points of support and resistance quite often depends on the individual trader, but there are some chart formations that clearly establish these points.

Old highs are considered resistance until they are taken out, and old lows are considered support until they are taken out. This often creates the 'double top' and 'double bottom' formations. These levels offer good trade entry points because the stops would simply be above the original high or below the original low. When a high gets taken out, it becomes support. When a support gets taken out, it becomes resistance. This is referred to as 'testing the breakout'. It is very common for a market to come back to its breakout point as its way of ensuring that it is moving in the right direction. This often will be an excellent entry point to establish a trade in the direction of the new trend. In Figure 7, we see examples of old highs offering resistance (double top), or an old low (support) becoming resistance. This old low also tried to hold support during the month of October, but eventually gave out and thus became resistance on subsequent rallies.

Support and resistance can also be found outside of previous price action. Many times a market will retrace a swing move by .318, .5, or .618. These are also known as Fibonacci numbers, which, according to mathematicians, conform to nature's law of physics. The theory behind using these number sequences is that everything conforms to the laws of nature and thus applying market behavior theory to this sequence will, over time, produce consistent results. The Fibonacci sequence is used in many other areas of technical analysis and will also be addressed when Elliott Wave is discussed.

I have found another type of chart formation to be of particular value when finding support and resistance levels. I refer to these levels as troughs. Again, the market should be a mechanism where, in theory, all price levels are traded and movement should be smooth and consistent. Obviously, this is rarely the case, which is how gaps get formed, how we have trading range breakouts, spike moves, and troughs, not to mention a host of other formations too numerous to mention.

Troughs are simply price extremes where the market doesn't trade as it's forming a bottom or a top. It is usually established by the high of the day's trading range when a significant low of a move is made, or the low of the day's trading range when a high of a move is made. These highs or lows often are levels to where the market will trade (filling the trough) in a correction to the trend. In theory, filling the trough is just the market trying to come back and trade the prices it missed while experiencing a change in direction. It might be easier explained graphically.

Figure 8 represent February '00 Live Cattle. Many of the troughs that were formed eventually found the market coming back to them as corrections in the trend. Most of the time, troughs will offer excellent entry points with the stop being beyond the swing high or low that formed the trough.