Last week in Part 7, we looked at Market Breadth. We now start a chain of eight articles covering technical analysis directly carried out on price. We will be looking at patterns, support & resistance, trends, Fibonacci, pivots, moving averages, bands, indicators and Ichimoku. The first of the eight, looks at Trends, Support & Resistance. Understanding these principles will give you the necessary building blocks to understand price action and analysis and evolve your technical analysis learning.
From the previous articles in this series, we know how to build some of the basic and most popular chart types. We now need to know what the chart is trying to tell us. We start with direct price analysis. Remember one of the key founding pillars of technical analysis: ‘Prices move in trends’? This is where we start – what direction over a period of time is the price moving in? This can be categorised into 3 simple classes: Up, down or sideways. The trend is measured through the analyst’s subjectivity, based around some loose rules, by manually drawing trend lines on to charts.
So, what is a trend? Its official definition: The general direction of a market or of the price of an asset.
All tools used by the chartist have the sole purpose of helping to measure the trend, with the expectation, as a trader, of participating in it.
Some basic trend rules:
- Markets trend roughly only a third of the time – so you need to know when it is happening!
- Other than being Up, Down or Sideways, trends have three time classifications:
- Major trend: 6 months to 1 year+
- Intermediate: 3 weeks to 6 months – where most ‘trend followers’ interact with the market.
- Near: < 3 weeks – used for timing purposes
- Trends don’t just move in straight lines. They move in zigzags and create waves.
- A tentative trend (Up): if price has 2 reaction lows with second higher than first – vice versa for down trends.
- A confirmed trend, if the price touches for a third time.
- Trend significance: the more times touched and the longer intact, the more important the trend is.
Example of trends within trends in the long, medium and short classification on the S&P500 (charts: TradingView)
Measuring trend length, is often down to the perception or objectives of the trader or the type of trader you are.
Some applications of trend line analysis:
- Using the trend for trading and investing? By understanding the direction of price, this then gives you three simple options to trade:
- Go Long
- Go Short
- Stay out
- Helps in measuring price objectives and when a trend is changing.
- Taking short term profits.
- Putting on counter trend positions.
- Trading the break.
- Once a trend line is broken, prices will usually move a distance beyond the trend line equal to the vertical distance that prices achieved on the other side of the line, prior to the trend reversal.
- Trend line steepness: most important trend lines average a 45 degree slope (similar principle used in Gann theory)
- Trend channel lines: prices sometimes trend between 2 parallel lines – if you recognise this ‘set up’ then you can trade between these two boundaries.
Drawing trend lines on to charts:
Better to use Bar charts / candlesticks (takes in whole days range) than line charts (closing prices). Draw trend lines through the lows in an up-trend and through the highs in a down-trend. It is a discretionary drawing process.
Example using the daily chart of Diageo PLC (charts: Stockopedia) with subjective trend lines applied:
Support & Resistance
A similar concept to the trend line, but with Support & Resistance analysis, we’re trying to dig into the psychology of price action. Trends do stop. They hit a brick wall either going up or down. They can repeatedly hit this wall until something else happens – price either gives way and it continues or it reverses. This is the concept of Support & Resistance (S&R).
A support level is the price at which buyers are expected to enter the market in large enough numbers to take control from the sellers.
The market has a great memory – it remembers! When price falls to a new low and then rallies, buyers who missed out on the first trough will be inclined to buy if price returns to that level. Afraid of missing out for a second time, they may enter the market again in large enough numbers to take control from sellers. The result is called a “rally”. This reinforces the perception that price is unlikely to fall further and creates a support level.
A resistance level is the price level at which sellers are expected to enter the market in sufficient numbers to take control from buyers. When price makes a new High and then retreats, sellers who missed the previous peak will be inclined to sell when price returns to that level. Afraid of missing out a second time, they may enter the market in numbers sufficient to overwhelm buyers. The resulting correction will reinforce market perceptions that price is unlikely to move higher and establish a resistance level.
S&R role reversal:
- Support levels, once penetrated, frequently become resistance levels and vice versa.
- The thinking behind this is fairly simple: buyers who buy near a support level, only to see price fall, are likely to sell in order to recover their losses, when price rallies to near their break-even point. The support level then becomes a resistance level.
- Likewise, traders or investors who sell when the price approaches a resistance level will be disappointed if price penetrates the level and continues to rise. They will be more likely to buy if price returns to near the support level, fearing that they may miss out a second time. The resistance level thus becomes entrenched as a support level.
Rules of S&R:
Some support and resistance levels are more important than others. The significance of the support level is identifiable by:
- The number of times that the level has been respected; (The greater times = the more important)
- The amount of volume that has been traded near the level; whether the level is old or new – recent levels have greater significance.
- Whether the level is a new High or new Low – more extreme levels have greater impact.
- A level formed at a round number (e.g. $20.00 or $100.00) leaves a lasting imprint.
The FTSE100 (Charts: Stockopedia) from mid 2016 to current with subjective support & resistance lines added:
Tools for measuring S&R:
Over the next few weeks we will look into some of the tools you can use to try and deduce where support and resistance levels are. Some that we will be looking at are:
- Manual trend line drawing
- Moving Averages
Further reading and learning:
If you are interested in learning more about trends, support & resistance then the following reading may help:
- Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.
- Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.
Understanding the trend allows you to conclude which direction you think price will move in, more objectively. Trend analysis allows you to decide whether to go long, short or do nothing. It can also be used as a trading system by itself. On top of trend analysis, knowing where price is going to head to or not head to, is critical for your risk management: entry, exit, target setting, stop loss processes etc. Combining trend line and support & resistance analysis together, gives you a powerful combination of tools to get you started in the analysis of price.
Next time: Technical Analysis (Part 9): Direct Price Analysis (DPA) – Patterns on Price