Trend Technician » stops

Technical Analysis Basics: Support and Resistance

admin — Sat, 29 Aug 2009 22:41:40 +0000

This article is part of the Trend Technician Technical Analysis Basics series. Be sure to read the rest of the series.

Probably the first type of chart analysis to come into play is the analysis of area areas of support and resistance. Support is a price level at which buying increases to either pause or reverse a downtrend. Similarly resistance is a price level at which selling increase to either pause or reverse an uptrend. This sounds complex, but is really quite intuitive in practice.

For the purposes of this conversation we’ll assume we’re talking about a stock, although this applies to any traded issue. Intuitively you can imagine that various members of the market see the stock as atractive at a certain level. As the price gets lower and lower more members start to see the stock as underpriced. This effects becomes manifest at a certain price at which there doesn’t remain enough selling power to push it down and the price ”bounces off” the support level. In this chart that price is roughly 87.

Support and Resistance (Blue and Red)

The same effect happens in the positive direction as well. As the price raises participants increasingly lose their conviction in the stock. Eventually it reaches a price at which equilibrium is reached, at least temporarily and the price “bounces off” downward. This is a resistance level.

Interestingly, like many technical indicators, this effect is more pronounced because other traders believe in it. As the price approaches a support level, more players will go long to see if the price will reverse. This additional buying tends to create a self-fulfilling prophecy.

Strength of Support and Resistance

These effects are easy to see in a chart. Over time there are obvious price levels at which price movements either slow down or stop their directional movement. The more times a price fails to penetrate a line of support or resistance, the stronger the effect is pereceived to be. Each time the bears or bulls fail to penetrate a given line, the less optimistic they will be about breaching it.

Addtionally support or resistance in longer term charts tends to be perceived as more meaningful than in short term charts. There are typically levels of support and resistance in each time period and they should be approach holistically. Don’t ignore the long term support and resistance just because you’re making a short-term trade.

Trading Support and Resistance

Prices Can Only Stretch So Far

Trading using support and resistance lines is very basic and should be considered in just about any strategy. Even the most complex strategy will usually pay heed to support and resistance lines. Support and resistance lines can provide great index lines for where to enter or exit trades. Additionally they can provide “stops” that indicate when your trade has moved against you.

In a simple example, when a stock “boucned” off it’s support, you might buy and then place a stop just on the other side of its support. Thus if you’re right, the price will continue away from the support and you will make money. If the stock moves the other way and pierces the support level, there is evidence you picked the wrong time to get in. Support and resistance levels also provide good places to tighten your stops in positions you’ve already taken.

Ultimatley noting areas of support and resistance will become second nature. They are both one of the most obvious and one of the most important components of chart analysis. It pays to pay attention to them.

Photo Credit: fazen

Don’t Trade Without a “Stop”

admin — Thu, 16 Jul 2009 21:11:23 +0000

If you’re trading without a “stop,” you are playing Russian Roulette with your money. “Stop Loss Orders” or “stops” are orders you place with your brokers to indicate that if your position moves against you to a certain point you will exit the trade. You have a “stop price” where if the issue trades at that price or worse, the order turns into a market order to sell or buy. Many traders don’t actually place the order but have a price at which they will exit the trade, which they still call a “stop.” In fact some traders prefer not to place an actual order because they fear they will influence price execution and get “stopped out” when they wouldn’t have otherwise. Regardless of how you execute the exit, you should never enter any position without a price at which you know you’re wrong and get out of the trade.

The Psychology of the Stop

The psychology of trading is fraught with peril. In many ways once the trade is on you can become fixated on making that trade work out. The problem is, when you’re doing the research and working out your trade, you’re perfectly rational. Once you’ve placed the order however, you can start lying to yourself and costing yourself money by convincing yourself to stay with a trade that’s turned against you. By always trading with a stop, you can set the extent of your trade while you’re still acting completely rationally. This can be a huge money saver.

When you’re deciding to enter a trade, you should be deciding a priace at which you’ve been proven wrong. You have reasons why you think the market is going to move in a certain way, which is why you’re considering entering the postion. You also need to set at what price your analysis no longer holds true and it’s time to get out. By doing this while you still have all your pros and cons fresh in your mind you can make the best decision and prevent yourself from taking unnecessary chances.

Moving the Stop

SPY With Parabolic

Another key thing to remember is that once you’re in the trade you don’t just forget about your stop. By moving your stop you can also keep from giving back all your profits or making other costly mistakes. Never let a profit run into a loss. Here you can see a subsection of a chart of the S&P 500 Index [Trend Analysis]. This chart has the parabolic indicator overlaid on it which is one strategy for moving your stop while in a trade.

We’ll discuss Parabolic in another article, but it provides a useful visual of how a stop might move during a trade. It also illustrates that this also doesn’t apply only when going long but when going short as well. You should always be looking for when you’ve been proven wrong and cut your losses when you have been.

You Don’t Have To Always Be Right

No one is right all the time, and trading with stops are simply a matter of managing your money to reflect this. If you are right only one half of the time but make more when you’re right than you lose when you’re wrong, you will have success. You are trying to play the odds and you want to make sure that when you’re wrong, you minimize the damage and that when you’re right, you maximize the reward.

Ultimately the stop is your protection from catastrophe. Many people don’t want to be wrong, but I’d rather be wrong with money than right without it. One key thing that many traders forget is that being stopped out of a trade doesn’t mean you can’t retake a position, it simply means it’s time to re-evaluate and make sure your trade still makes sense or wait until it does again.

Photo Credit: Kass & Rachel