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Part 4: Key Aspects of the Chart: Resistance and Support
Great attention has to be paid to the concept of the trading range. Technical analysis is based on the study of relationships between price and how it moves toward (or beyond) resistance and support levels.
Resistance and support represent the borders of the trading range, so any important reversal signals found at or near these levels is going to have more meaning than the same signals appearing at midrange. If price moves above resistance or below support, reversal is highly likely as well. At these points in the price trend, resistance and support levels are tested. Will price retreat, reaffirming the current trading range? Or will it continue above or below, setting a new trading range for the underlying security?
Swing traders especially are aware of some facts concerning resistance and support, such as the following:
1. Reversal is more likely at the trading range borders than anywhere else. The resistance and support price levels—whether horizontal or dynamic—are the true tests of trend strength and momentum. The appearance of a reversal signal gains power and importance when it shows up at these levels.
2. Gapping price movement through resistance or support adds to the likelihood of reversal. Confirming a reversal signal, gapping price action adds to a likely reversal. This is especially the case when the gap takes price above resistance or below support; price is then likely to reverse and fill the gap, but if it does not, then the newly set trading range is even stronger. Another condition worth watching is the runaway gap, a series of price gaps over several sessions moving through resistance or support. This demonstrates strong momentum and adds to the likelihood that the breakout will hold.
3. These price levels are guidelines only, but they are important. Swing traders do not care whether prices move higher or lower; they only want to be positioned to exploit that direction and to recognize reversal when it occurs. Resistance and support are the “red zones” of reversal where price direction and momentum matter the most.
Reversal and support come in several shapes and sizes. They are crucial to effective swing trading, so six different types are illustrated below.
First is the standard horizontal trading range, in which both resistance and support remain at the same level with prices ranging in between. For example, Wells Fargo’s chart in figure 2.1 displays a horizontal trading range for six weeks before prices broke out above resistance. Notice how price levels tested resistance briefly but never closed above it and how support was tested three times. All of these tests were in the form of upper and lower shadows, but no opening or closing price levels violated the trading range.
The second type of trading range pattern is the triangle. In this format, one side or the other remains flat while the other side narrows and moves toward the first. This creates a triangle, which is a continuation pattern. For example, the chart of 3M in figure 2.2 consists of flat resistance and rising support. As a continuation would be expected to behave, once the triangle narrowed, price levels broke through and moved above resistance.
The wedge is similar to the triangle, but this is a reversal formation. In the wedge, both resistance and support move in the same direction, but the range narrows. This is an exceptionally strong reversal signal. For example, in figure 2.3 Yahoo! has two different wedges, a bearish reversal and then a bullish reversal. At the conclusion of the first (bearish) wedge, a large downward gap confirmed the bearish change of direction. However, even as price levels continued to decline, a bullish wedge formed, predicting a reversal to the upside. In fact, by the end of the period the price level had returned to its starting point.
Some trading ranges remain consistent in terms of breadth of trading between resistance and support, even as price levels rise. This rising range provides a degree of certainty, especially if the breadth remains consistent over an extended period of time. For example, in figure 2.4 Exxon Mobil rose consistently over a three-month period, but the trading range remained within 2.5 points. A single decline below support quickly reversed back into range.
The range may also decline over time, and the tendency described above may be observed. The breadth of the range remains a constant even when overall price levels fall. For example, on the chart of Potash Corp. in figure 2.5, a sharp decline over five weeks occurred, but the breadth remained within 2.5 points. Some momentary moves both above resistance and below support were corrected immediately.
Trading Range Flip
A final pattern worth noting is the so-called flip. When prices move through resistance and remain there, the previous resistance level often becomes the new support level. When prices break out below support, the prior support becomes new resistance. The flip is useful in determining whether or not the breakout is going to hold. As the newly set borders are tested and hold, the likely establishment of a new trading range is confirmed. For example, as shown in figure 2.6, DuPont experienced an uncertain rise above resistance, then a retreat and a second try. The indicated new support became the test price; as long as price does not fall below that level (prior resistance), it means the new support is likely to hold.
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