Seguici su Facebook
From Traderencyclopedia
Jump to navigation Jump to search
Resistance. Theoretical model.
«In investing money,
the amount of interest you want should
depend on whether you want to eat well or sleep well.»

(Kenfield Morley)

A resistance is a price zone where the selling pressure or the lack in demand is such to prevent, at least temporarily, a further rise in prices which may result in a possible trend reversal. Once it is broken, a support becomes resistance, as well as a resistance, once broken, becomes support. Supports and resistances are not necessarily horizontal levels.

Operating with resistances

The concepts of support and resistance are fundamental in technical analysis. To better understand them, we can imagine a big man who is so heavy to be able to crack a floor just by jumping on it. If his action is weak, every attempt to breach through the floor will be futile and the floor will be strong enough to remain intact. That’s a perfect support!

Conversely, if the man acts with sufficient strength and decision, the floor will collapse under his feet and he will be find himself falling through the ceiling to the floor beneath. Therefore, what worked as a floor earlier now works as a ceiling and the man will need a huge amount of energy to return above that level again. All his attempts to do that will eventually end up with a frustrating failure, so this is the case in which a support becomes resistance.

A violated support become resistance as a violated resistance become support.

We have two ways to work with resistances and supports:

1. Wait for the price to cross over the resistance in order to enter a long position, placing a protective stop order right below the level that now should become support;

2. we enter a short position by placing a sell stop order at the resistance level.

It is necessary to carefully evaluate the strength of supports and resistances. Many traders sell right below resistances and buy at supports, but not all the levels have the same reliability, it is necessary to learn to understand the context.

In the following theoretical model, either a support and a resistance are shown. It may either be the case of a double top or just a retracement in a well defined trend. In the latter case, the first high would be easily without too many difficulties. When we look at chart formations after they took place, they seem clear and evident. So the chartist’s main ability is being able to understand the contest behind the moves.

buy, sell, or wait for a clear sign?

During retracements, resistances are more “sensitive” when price is in a downtrend, while supports are more “sensitive” when the price is in an uptrend. We therefore need to realize what the underlying trend is, especially when we are operating on an intraday basis.

If price is in a clear uptrend and near a resistance level, we have different operative scenarios:

1) A quick but risky counter-trend position (short);

2) We wait for the end of the eventual retracement to enter a long position;

3) We wait for the break above the resistance.

In a clear uptrend it doesn't make too much sense to wait too much. Being too prudent is as counterproductive as not being prudent at all. The same goes for what happen in a downtrend, but in the opposite sense. During those days in which the price is strongly trending, resistances and supports get burned like matches. It is necessary, therefore, to be aware of the trend in which we are acting. Contextualization is essential!

Supports and resistances validation methods

A price chart is absolutely not the best tool at our disposal in order to acquire quick information on whether or not a resistance level will be able to hold back the price. It is necessary to carefully study price, as it is getting its shape. In other words, we also need to analyze the book.

In order to avoid false signals, there are some criteria with which we can establish the reliability of support and resistance levels

1) A first method is based on the measurement of the distance between those price levels which form the resistance. The greater the distance, the greater the pressure that prices will encounter at the examined level. The market remembers, even after many years, old supports and resistances, but it depends much on whether or not we are approaching historical highs and lows or a level that is part of the current trend.

2) Volumes play an important role as well. The more the contracts traded at the previous high (low), the stronger the resistance (support) will be, once the previous level has been violated: there will be in fact a greater number of traders who will be interested in getting out of (entering) a position, once the new level is reached.

3) Supports and resistances on long-term charts are way more important than those observable on short-term timeframe . A messed picture on a daily chart might be clearer on a weekly chart or on a monthly chart.The fact that price is hitting a daily resistance is less important than the fact that price has just been repealed by a weekly support level. The strength of supports and resistances is inversely proportional to the time passed from their formation.

It is important to remember that an uptrend is theoretically made of higher highs and lows (decreasing in a downtrend), therefore the simple fact that prices get stopped near a previous high or low should be seen as an alert signal. The failure in making new higher highs or lows can imply a trend reversal or the shift from a trending condition to a ranging one, in other words from a well defined tendency to an undefined sideways movement.

In this sense, it is interesting to mention the pattern known as “broadening”, characterized by the great amount of false signals, especially when we apply the typical operative criteria of supports and resistances. A wannabe trader, lacking of the necessary experience, will face a true nightmare when he sees a broadening pattern: a series of false signals that can easily erode both the mind and the account.

This formation totally goes against the classical trend-following approach which assumes that an uptrend will continue when prices, following a retracement, break above the previous high. Once the resistance (r1) is found, the r2 follows and then a third one (r3). Each time a resistance is created, a support got violated taking out the related stop loss order.

Effetti letali della broadening formation.

Other supports and resistances

It often happens to observe how horizontal lines can work, in more than one occasion, alternatively as support and resistance levels, especially when these lines overlap with important highs and lows. The effectiveness of these lines in holding back the price remains unchanged even after many years. Surprisingly!

  • Dynamic levels. In addition to static supports and resistances, we also have dynamic supports and resistances, the value of which changes in time and that are possible to identify by applying two common technical tools: trendlines, with their parallel projections, that enclose the price into a channel underlining the dominant trend, and moving averages that in some cases really seem to walk with the price. Of course, in this latter case, the major problem is finding the best fitting period with which to build the average: again, the experience comes into help, telling us that the 20-21 period and the 50 period moving averages are the most interesting calculations, while the 200 period moving average works as a long term support or resistance level.
  • Patterns. A head and shoulders neckline, or the peak of a triangle or yet a side of a triangle are nothing more than supports and resistances, expressed as dynamic levels most of the time.
  • Pivot points. These are support and resistance levels that are calculated thanks to particular formulas. They lack of a graphic relevance, but still they are very effective. Pivot points are monitored especially during intraday trading sessions.
  • Round numbers. Sometimes, especially when prices pop up from absolute highs or absolute low, we find ourselves lacking of significant further levels. In these scenarios, the only indications we may be able to get, except from dynamic levels, can come from the so called “round numbers”. Essentially, we can look at round numbers as natural support and resistance areas, where we can think to set our targets.

In conclusions

Supports and resistances are to a chartist, what a ruler is to an architect: a simple but basic tool. A tool that is necessary to know and that have to be used in conjunction with other tools, that may certainly be more complex but not necessarily more important or exclusive.

Vedi anche: