Fundamentals of Technical Analysis and Algorithmic Trading Chapter 7: Support and Resistances

DoğuAkdenizÜniversitesi Faculty of Business and Economics Department of Banking and Finance Fundamentals of Technical Analysis and Algorithmic Trading Chapter 7: Support and Resistances SaeedEbrahimijam Spring 2012-2013 FINA417

Contents • Support and Resistance Defined • Role Reversal • Trend Reversal • Percentage Retracement • Speed Resistance Lines Fundamental of Technical Analysis and Algorithmic Trading

In the Wall Street environment, the terms support and resistance are almost synonymous with demand and supply, respectively. • Support is a price level at which there is adequate demand for a security to stop its downward price movement and, normally, turn prices upward. • Support occurs at reaction lows. Fundamental of Technical Analysis and Algorithmic Trading

Fundamental of Technical Analysis and Algorithmic Trading

Resistanceis a price level at which there is a significant supply of a stock causing prices to halt an upward move and, typically, turn prices down. • Resistance occurs at reaction highs. Fundamental of Technical Analysis and Algorithmic Trading

In an uptrend, both support and resistance levels rise. • Typically, support levels hold while resistance offers temporary halts to upward movements in prices. Resistance levels are repeatedly broken until the uptrend is reversed. • In a downtrend, both support and resistance levels move lower as illustrated in Figure 7-4. • Typically, resistance levels hold while support levels temporarily stop downward price movements. Support levels are repeatedly broken until the downtrend is reversed. Fundamental of Technical Analysis and Algorithmic Trading

Be aware of round numbers, Round prices have psychological affect that stop price trend. • Don’t buy, don’t sell exactly on round numbers!!! • How to sell short in down trend? - Sell price< current (round)price - STOP LOSS> round number Fundamental of Technical Analysis and Algorithmic Trading

ROLE REVERSAL • In an uptrend, resistance levels often become support levels after they are broken significantly as illustrated in Figure 7-5. • In a downtrend, the opposite occurs as support levels frequently become resistance levels. (See Figure 7-6.) Fundamental of Technical Analysis and Algorithmic Trading

The likelihood of role reversal, from support to resistance or resistance to support, depends on three factors : • First, the greater the volume that occurs at a support or resistance level, the more significant the level is. - So, the more likely a candidate the level is for role reversal. • Second, the longer that prices trade near the support or resistance level, the greater the chance of role reversal. -for example, the probability of role reversal is enhanced if consolidation occurs near a support or resistance level for a few weeks rather than a few days. • Finally, the more recently that trading occurred at the level, the fresher it is in traders’ minds, and the more likely it is that role reversal will occur. Fundamental of Technical Analysis and Algorithmic Trading

TREND REVERSALS • In an uptrend, a trend reversal occurs when prices are held at a resistance level. A double top or some other reversal formation develops at that point, and the trend changes direction as illustrated in Figure 7-7. Fundamental of Technical Analysis and Algorithmic Trading

A trend reversal occurs in a downtrend: • when prices are unable to penetrate a support level. In this case, a bottom reversal pattern is formed, and the trend changes direction to the upside as illustrated in Figure 7-8. Fundamental of Technical Analysis and Algorithmic Trading

Keep in mind that: • a trend reversal is not signaled by the first failure to break through a resistance level (in an uptrend) or a support level (in a downtrend). - A reversal pattern must fully develop before one gets the signal that the trend has changed. • In other words, a trader should not rush to sell all of his or her securities or sell short just because prices have held at a resistance level. • Likewise, one should not load up on securities or cover short positions just because prices initially fail to penetrate a support level. “ Wait for more evidence that a trend reversal is occurring.” Fundamental of Technical Analysis and Algorithmic Trading

PERCENTAGE RETRACEMENTS • After prices move either up or down for a period of time, they usually move in the opposite direction, retracing a portion of the previous move. Subsequently, prices continue in the original trend direction. Fundamental of Technical Analysis and Algorithmic Trading

Countertrend price moves frequently move by a percentage range amount. Often prices will retrace from a minimum of one-third (or 33 percent) to a maximum of two-thirds (67 percent) of its previous move before continuing in its original trend direction. Figure 7-9 illustrates a 50 percent retracement, which is very common. • RULE OF THUMB: Some traders view a retracement of 33 to 50 percent as a buying opportunity in an uptrend or a selling opportunity in a downtrend. • The two-thirds level is a critical area. If prices move past the two-thirds retracement level, a trend reversal is likely. Note: If the downtrending stock retraces more than 66% of the recent decline, then the downtrend is likely to reverse to an uptrend. Fundamental of Technical Analysis and Algorithmic Trading

SPEED RESISTANCE LINES • Developed by the late EdsonGould. • Speed resistance lines (also known as speed lines) are based on a theory that trends are divided into thirds. • Unlike percentage retracements (that look at just price movements in terms of thirds), speed resistance lines look at both price and time. • Speed resistance lines measure the rate at which a trend moves up or down. Fundamental of Technical Analysis and Algorithmic Trading

In an uptrend, speed resistance lines are constructed by dividing the vertical distance from the beginning of the trend to the highest point on the chart. That distance is then divided into thirds. Two trendlines are drawn as illustrated in Figure 7-10. • The first trendline is drawn from the beginning of the trend to one-third of the way up the vertical distance. • The second trendline is drawn from the beginning of the trend to two-thirds of the way up the vertical distance. Fundamental of Technical Analysis and Algorithmic Trading

Figure 7-11 illustrates the construction of speed resistance lines in a downtrend. The principles are similar to those used in construction of speed resistance lines in an uptrend. Fundamental of Technical Analysis and Algorithmic Trading

How do you use speed resistance lines? • It is simple. If, in an uptrend, prices have reached a new peak and are retracing (or correcting) some of the upward movement, they will frequently stop at the two-thirds speed resistance line. If prices do not stop at the two-thirds line, they will probably move to the one-third speed resistance line. If they are not held at the one-third line, a trend reversal is signaled. Fundamental of Technical Analysis and Algorithmic Trading

In a downtrend, breaking the two-thirds speed resistance line suggests the likelihood of a rally to the one-third line. If that is penetrated, a trend reversal is probable. Fundamental of Technical Analysis and Algorithmic Trading

How to draw SRL • SRL is constructed by drawing a line from the most recent high of the uptrend down to the low of the same trend. • Then you must divide the line into a third and then again into two-thirds. • Having this done, the chartist will draw a line from the low point of the trend through these two points. • The lines you have now created show the possible support on retracement. • When studying a chart wherein a downtrend is occurring, one needs simply to reverse the process just discussed: every time an issue creates a new high or a new low, the speed resistance lines must be redrawn. Fundamental of Technical Analysis and Algorithmic Trading

First Line: High to Low • Middle Line: High to 2/3 point • Upper Line: High to 1/3 point • 2/3 point: High - (High - Low) x .667 • 1/3 point: High - (High - Low) x .333 Fundamental of Technical Analysis and Algorithmic Trading

Uptrend First Line: Low to High • Middle Line: Low to 2/3 point • Lower Line: Low to 1/3 point • 2/3 point: Low + (High - Low) x .667 • 1/3 point: Low + (High - Low) x .333 Fundamental of Technical Analysis and Algorithmic Trading

SRL Interpretation • Speed Resistance Lines work the same as ordinary trend lines. • They can be used to estimate support or resistance levels and to define the trend. • In an uptrend, Speed Resistance Lines mark two potential support levels to watch. - A break below the middle line targets a move towards the upper line. A break below the lower line indicates enough weakness to consider a trend reversal. - Once broken, the line extensions can then mark resistance, just as ordinary trend lines. • In a downtrend, Speed Resistance Lines mark two potential resistance levels to watch. - A break above the middle line shows strength that targets a move to the upper line. A break above the upper line indicates a trend reversal. Once broken, these Speed lines can then turn into support on a pullback. Fundamental of Technical Analysis and Algorithmic Trading

Fundamentals of Technical Analysis and Algorithmic Trading Chapter 7: Support and Resistances