Support and resistance: A wave tendency

June 30, 2012 07:00 PM

While there is no such thing as the perfect trading system, certain points on a price chart reveal high-probability opportunities that can lead to some of the best moves in financial markets. There are areas in the pattern that act as magnets to the price action. Understanding where they are allows traders to exercise greater discipline and achieve greater consistency. 

Many traders like to pick tops and bottoms. Sometimes they’ll be right, but nobody is right all the time. Through extended observation, say a person who picks a top or bottom is going to be correct about five or six out of every 10 tries. That might seem like a mediocre statistic, but it takes a lot of skill to bat even 50% forecasting significant turns — something that happens far less than half the time in the markets.

As most traders know, the first move off a high or low doesn’t go far. It’s always a smaller move and generally retests the high/low or goes sideways for an extended period as it sets up for the larger move. Say the trader who attempts to pick the top or bottom rides the first leg and gets caught in the frustrating sequence of the retest. Unless the trader is really good at scalping or swinging on an hourly/daily time frame, he or she will give back a portion of those gains. But if there’s a re-entry on the reversal, and the target is first support/resistance, enough money must be made to make up for the four-to-five times out of 10 that the trader was wrong. If your winners amount to that small first leg of a new move, then you likely aren’t making the money you need on the winners to be profitable over time. 

The polarity flip

Traders have preached through the ages that once you get a winner, you have to let it run. Professional athletes like to talk about how the coach puts the team in a position to win. By understanding the type of moves that can run, the trader finally puts himself in a position to win.

One of the easiest ways to make that happen is to be aware of the polarity flip. Simply put, an area of resistance will turn into support and an old area of support will turn into resistance. Once this phenomenon materializes in a pattern, it leads generally to outstanding moves that put the trader in a position to stack big profits as he lets the winner run.

Let’s review a simple example on a large time frame. “Bull to bear” (below) shows the top of the 2007 bull market in the Dow and the beginning of the bear market. The price action comes down to a near-term support area, which is close to old support on the way up. It bounces then drops to a new low. A multi-week rally materialized, but all it could do was come back to the ridge of old support. Why does this happen?

It could be that late bulls who bought in near the old top didn’t realize they were buying the top and quickly found themselves underwater. By the time that happened, they realized their mistake and attempted to exit as close to breakeven as possible. Smart bears, who realized the trend might be turning, were eager to short the market. The combination of late bulls and timely bears led to the big move south.

Instead of trying to pick the top and suffering through the early stages of a new move, if the trader realizes the flip in polarity generally leads to what proponents of Elliott Wave analysis call the third wave, he puts himself in a position to win more with less risk. While this is an extreme example that preceded the financial crisis, what generally happens in these circumstances is the best move does materialize at this point. 

Wave tendencies

“Slow turn” (below) depicts the top of the oil market in 2011. The first leg down doesn’t give a retest of the peak but instead turns sideways for 24 days before dropping to retest the area of support. The retest goes no higher than former support but turns into a 25% drop. This setup introduces the next condition, which is the A-wave tendency line.

Elliotticians label moves with numbers or letters. A five-wave impulse is just that — the fifth move of the larger trend. The corrections in those legs are labeled with letters: A, B and C. For simplicity, the first move off a high or low is either a one-wave or an A-wave and is called the “A-wave tendency line.” It doesn’t matter if it’s an impulse or correction because the behaviors are the same and can be traded in any time frame. 

“Setting up” (below) is a recent intraday move in gold. In this case, the move off the low slowly drifts higher until it levels off. It doesn’t have to retrace the bottom necessarily, but you can see a smaller pullback inside the move higher that tests the initial breakout; this is likely an A-wave tendency line on a five-minute chart.

In the bigger picture, the price gaps up beyond the A-wave. It finally pulls back in a bigger way. Traders should look for an edge where any potential pullback might resolve itself. In this case, and in many cases, that area will be the polarity flip and the A-wave tendency line.

Confirmation

Once the polarity flip and the A-wave tendency line materialize, a confirming candle formation typically develops and the market explodes into a new trend. It’s always important to use another signal to time the trade. This can be the candle or simply keying off an important support or resistance line.

While there still are going to be traders who choose to pick the turn, anticipating the polarity flip is a good strategy for those who may have missed earlier entries and want to position themselves as the move develops. While the whole move is not shown in “Setting up,” this particular setup did lead to a 49-point move in two trading days. 

These principles work in any market, especially stocks. “Down drift” (below) is a recent example in Alcoa (AA). The initial move down stops at the ridge of support for the last leg up. Similar to the Dow example, the stock drops slightly lower and recovers to test former support. It tests the A-wave tendency line not once, but twice. When it finally fails, it leads to the most consistent move in the sequence.

This methodology works on any time frame. “Day test” (below) is an intraday E-mini S&P 500 chart that includes what could be called an ABC pullback because it has two thrusts in the same direction. In this case, the pattern reverts all the way back to the A-wave before a 17-point move materializes in six hours.

These techniques for honing your ability to more safely time tops and bottoms are not the only types of support and resistance lines. There are double tops and bottoms (some of the most reliable patterns), Andrews and trend channel lines, as well as areas of Fibonacci retracements and extensions.

One of the finer points to realize is that traders don’t have to concern themselves with the news. Generally, what later will be defined as an important news event will materialize near these important magnet points on the chart. Nor are the technicals always precise; other times, the pattern will not give a perfect touch of the polarity line. It only will come close.

To be successful, you have to become comfortable in an uncertain environment. Not everything is wrapped up in a neat package. Sometimes, the pattern will undershoot or overshoot the line. The best that traders can hope for is to manage the probabilities.

It’s also important to combine this method with an additional signal. A confirming candle is probably the best tool. If the candle reversal signal does not look good on a larger time frame, it might be necessary to adjust your expectations. In other words, if you were hoping for a reversal on an hourly or daily chart, but find a confirming candle only on a 15-minute basis, the market may be hinting that the move isn’t going to be as big as anticipated. 

In the end, these methods may work because trading is a zero sum game. For every winner, there is someone on the losing side of the trade. That being said, the people who end up winning may give up their shares/contracts because they are satisfied to take the first part of the move, or market fluctuations might shake out the weaker hands. Traders who play the move off the high or low do get frustrated and exit on the first correction. They give up their positions to the stronger hands, who stick with the move through to the end of the trend.

Jeff Greenblatt is the author of “Breakthrough Strategies For Predicting Any Market,” editor of the “Fibonacci Forecaster,” director of Lucas Wave International LLC and has been a private trader for the past eight years. 

About the Author

Jeff Greenblatt is the author of Breakthrough Strategies For Predicting Any Market, editor of the Fibonacci Forecaster, director of Lucas Wave International, LLC. and a private trader for the past eight years.