Price action trading: Support and resistance

October 31, 2014 07:00 PM

Ed Note: This is the forth of a six-part series that provides an overview on how to trade using price action on all time frames and in all markets.


Although there is no universally accepted definition of price action, I use the broadest one--it is simply any move up or down on any chart for any market.

Traders must understand support and resistance if they are going to trade profitably, and there are many more forms of support and resistance than what are usually discussed. In particular, there are many measured move targets that the computer algorithms chase, but are never mentioned anywhere. You can learn to spot them if you study charts and keep asking yourself, “Why did the market just do that?” Everything has to make sense, so if something happens and you do not understand why, assume that you are missing something. Over time, you will miss less and less and eventually you might conclude that every tick matters and makes sense. 

Support and resistance are magnets that draw the market to them. As with any magnetic field, the closer the market gets, the stronger the magnetic pull, and the more likely it is that the market will reach the target. Also, as with a magnet, the market often accelerates when it gets close to the magnet. This momentum often results in either a strong breakout or a climatic reversal. Once the market reaches the target, the magnetism usually greatly decreases. It is as if the market turns off the magnet once it is reached.

If the market reverses or breaks out, it then moves to the next support below or resistance above. In a strong bull trend, resistance usually results in a pause because of profit taking or attempts to pick a top, but the trend then resumes up to the next resistance level. In a bear trend, the market usually falls through all support, although it often pauses at each level because of profit taking or attempts to pick a bottom. All bull trends end at resistance and bear trends end at support, and if traders know how to read the changes in buying and selling pressure, transition usually provides several trades in both directions.

The most widely used support and resistance levels are moving averages, trendlines and prior highs and lows. I pay more attention to trendlines and prior highs and lows, but I do look at a 20-bar exponential moving average on intraday charts and 50-, 100-, 150- and 200-bar simple moving averages on daily and weekly charts. On monthly charts, I am primarily interested in trendlines and prior highs and lows. In a bull trend, if there is a trading range below, the top of the range is support. If there is a trading range or significant low above, it is resistance. In a bear trend, the opposite is true.


Trading with trendlines

There are many ways to draw trendlines but it is helpful to use the same approach on all time frames. It can be as simple as drawing a line across a series of highs or lows. It is helpful to create channels, which means drawing lines above and below. The channel goes up in a bull trend, down in a bear trend and sideways in a trading range.

The lines converge in a triangle and diverge in an expanding triangle. When a triangle slopes up or down, it’s a wedge. However, I use the term loosely, and I call any diagonal pattern a wedge if it has three pushes, even if the channel lines are parallel and not convergent (wedge shaped). It does not matter because the pattern functions the same as a textbook wedge.

Pivot points and Fibonacci numbers provide numbers and few reliable trades compared to other forms of price action. Just think about the E-mini intraday chart. On an average day, the range might be 40 ticks. With all of the significant highs and lows during the day and over the previous few days, there are probably 40 or more Fibonacci retracement and extension levels that you can find. 

Also, Fibonacci traders allow the market to miss a target by several ticks and still consider the move a Fibonacci level. This means that there are more Fibonacci targets than ticks in the day’s range! The result is that many profitable short-term traders ignore them based on experience. 

What about all the Elliott Wave theory, sea shell spirals and laws of nature? It is nonsense and has no rational basis in trading. Yes, some computers use 62% retracements in their algorithms, but far more computers use other aspects of price action. The market might sometimes turn at a Fibonacci level, but this usually is more the result of coincidence. There are so many Fibonacci levels that some will coincide with much more rational and widely used support and resistance, and when the market reverses at a Fibonacci level, it is much more likely due to something else. 

Although a 50% retracement is important to traders and it is a Fibonacci number, it has nothing to do with Fibonacci, but rather common sense. Markets exist so that buyers can buy and sellers can sell and both want a fair price, which is usually in the middle. If you want to buy a house, you will offer well below the asking price, and both you and the seller know that the final price will be approximately in the middle. Markets are constantly searching for the best value where bulls and bears are equally satisfied and dissatisfied, and that price is usually near the middle of the probes up and down.

There are other logical factors as well that have to do with the Trader’s Equation. For example, traders tend to go for profit targets that are one or two times greater than the risk. If the market sells off 100 ticks and bounces, a bear looking for a reward equal to his risk will wait for a 50% bounce and then short. He will risk 50 ticks to above the high and try to exit on a test of the low, 50 ticks lower. Because he believes that the sell-off was strong and the low was likely to get tested, he concludes that the probability of his short is high. One can assume that this means 60% or higher. From the Trader’s Equation, you know that you don’t need a huge reward when the probability is high. In fact, you only need a reward equal to your risk. You can then be confident that you only need a 50-tick profit to have a logical trade. 

Gaps

Measuring and exhaustion gaps are present on every intraday chart. Because they are so reliable, the computers clearly are using them for profit taking and reversal trades. When you look at a daily chart, gaps are often easy to see. If today’s low is above yesterday’s high, the space is called a gap. When a gap occurs early in a move, it is called a breakaway gap. When it occurs in the middle of a move and the move ends around a measured distance from the gap, it is called a measuring gap. When a gap occurs late in a move and then the market reverses, it is an exhaustion gap. 

Actual gaps like this occur on intraday charts, especially in thinly traded markets, but are extremely rare in major markets. However, there are other important gaps that commonly form intraday, but are not so obvious. For me, a gap is a space between any support and resistance area. While an intraday gap is forming, if you are aware of it, you can be prepared. You can often place trades using stops that are only two or three ticks from your entry price. That immediately tells you that your probability is low and your reward is big compared to your risk, but the math works out and the computers often take these trades.

An obvious example is if the market rallies to a resistance area, pulls back and then rallies one more time. There will always be computers placing orders to go short at one tick below the first high, risking to one or two ticks above, and betting for a double top and measured move down. Even if the probability is only 20% in a particular case (it often is 40% or more, depending on the context), if the reward is 10 times greater than the risk, the Trader’s Equation is strong.

Many computers use tick charts and examine every tick, constantly assessing the strength of pullbacks. For example, if there is a bull breakout and then a pullback, the computers will know if the pullback fell below the low of the breakout point, or if did not and there was therefore a gap. If the pullback held above support, the gap created is a sign of strength and often becomes the middle of a move. The computers will decide where the move began and then look for a measured move up where they will take profits or go short. Similarly, if a bar on the 60-minute chart is a bull measuring gap, the low of the bar after the gap bar is usually a clear swing low on the five-minute chart, and the high of the bar before it is usually a clear swing high on the five-minute chart. The space between is the gap and it often will end up as the middle of the move up.

I pay attention to a particular type of gap when the market is in the earliest stages of a possible reversal. For example, look at the five-minute E-mini chart in “Exhaustion gap” (below).

Notice how the close of one bar is above the high of the prior bar and that the low of the next bar did not fall below that high. This is a sign of buying pressure and increases the chances that the market will continue higher, at least enough for a trade. It is also a potential measuring gap. Look what happens once the market rallies to the measured move target. The small pullback means that the computers took partial profits at the measured move target. These gaps are present on all time frames and are important signs of strength. 

In strong trends, I also look for gaps because if they begin to fill, then countertrend trades are often profitable. For example, look at how the first gap stayed open, but how the second one closed. Trends tend to weaken as they progress. Pullbacks become stronger and deeper as the market transitions from the trend channel phase into the trading range phase. Once pullbacks begin to retrace beyond breakout points, traders will begin to fade new breakouts and scale in for scalps.

Measured moves

The most commonly discussed measured moves are leg 1 equals leg 2 moves and measured moves based on reversal patters, such as double tops and bottoms or head-and-shoulders patterns. While both are important, there are many variations of them, and the more that you understand, the better you will trade.

Intraday gaps often lead to measured moves. As a potential gap is forming, traders often enter during the breakout, expecting the measured move to follow. Once at the measured move target, traders will take profits while other traders will fade the move, hoping for a reversal. If the trend is strong when it reaches the target, there will be almost only profit taking and little trading in the opposite direction.

However, if there is a second entry, more traders will be willing to take the trade. For example, if the market races up to a measured move target or any other resistance, pulls back, and then tests the resistance again, bears will be more willing to short if this second rally looks weak or begins to turn down. This is a second signal and has a higher probability of success. 

Most tops come from some type of double top and most bottoms come from double bottoms, but the majority of these tops and bottoms are not even close to exact.

If a trader understands what the market is doing, he will be able to see double tops and bottoms that most traders would consider too imperfect to trade. For example, a strong bull breakout might have a one bar pullback and then another big bull trend bar. If the following bar is a bear inside bar or reversal bar, this is a possible double top sell setup if the context is good (see “Measured moves,” below).

Late in a trend, after it has gone for 20 or more bars, if it suddenly has the strongest or two consecutive strong trend bars with big gaps, this usually is an exhaustion gap that will be followed by a bigger pullback. Look for about 10 bars and two legs. The market tries to retest the start of this final breakout. In a bull trend, this means that the minimum target for the pullback is a test of the low of the first bar of this final breakout, which will usually also be a test of the moving average. If long, take profits. If flat, short the close for a scalp down and scale in higher, using a protective stop that is greater than the height of this final breakout.

Another common gap occurs late in a trend and I call it a Moving Average Gap Bar (see “MAG bar,” below). For example, if there is a strong bear trend that now is having a rally, and one or more bars now are completely above the moving average, these are gap bars (there is a gap between the low of the bar and the moving average). Traders often will short on a stop one tick below the low of the prior bar, looking for a test of the bear low. However, because the rally was strong, this sell-off will usually be followed by a Major Trend Reversal and a two legged move up. The reversal up usually will last at least one third as many bars as there were in the bear trend.

 

The next article will cover how to trade during different parts of the market cycle, and the concept of always being in, long or short.


Al Brooks, MD, has traded for his personal account for 27 years. He is a regular contributor to Futures and the author of a three-book series on price action published by Wiley: Price Action Trading: TRENDS; Price Action Trading: TRADING RANGES; and Price Action Trading: REVERSALS. He also provides live intraday E-mini price action analysis and free end-of-day analysis at www.BrooksPriceAction.com. His 36-hour-long video trading course is available at www.BrooksTradingCourse.com.

About the Author

Al Brooks, M.D., is author of the Brooks Trading Course (27 hours of videos at BrooksTradingCourse.com), several books on Price action (Reading Price Charts Bar by Bar: The Technical Analysis of Price Action for the Serious Trader, Wiley, 2009, and the 500,000 word, three-book series, Trading Price Action, Wiley, 2012), and numerous articles in Futures Magazine. He also provides live intraday E-mini price action analysis and free end-of-day analysis on www.brookspriceaction.com.