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14

confirming a probable trend change. The violation of significant support and resistance is often the final confirmation of an important change in market trend and is often the prime entry point for our trades. The information that follows is of vital importance to logical, scientific chart analysis. For our trading purposes we will define three categories of support and three categories of resistance.

STRUCTURE

Each specific category of support and resistance derives its classification from the number of bars prior to and following the specific support or resistance point we are attempting to pinpoint on our price chart. For instance, Category 1 support requires that only one bar previous to and one bar following the support point in question have a higher low than the bar that actually marks our point of interest. Category 2 support requires that two bars previous and following have higher lows, while Category 3 support obviously requires three higher bars on each side of the point we are defining with our chart formation. We will now proceed to define more accurately each of our six critical chart formations. Lets begin our specific discussion of this vital concept with Category 1 support and resistance.

Category 1 Support and Resistance

Resistance

To pinpoint this particular resistance level we must recognize two separate, simple patterns. First, the bar immediately prior to our resistance level must have its high lower than the high of the bar that is our Category 1 resistance level. Additionally, there must be a bar immediately following our resistance point whose high is lower than the high of the bar pinpointing Category 1 resistance. Obviously, the name "Category 1" is derived from the fact that only one bar before and one bar after the resistance point are required for its formation.

Examine Figure 7.1 for a chart example of Category 1 resistance. The series of gray ellipses on this chart designate the chart patterns we will discuss here.

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Figure 7.1 A Category 1 resistance point is defined as the high of a bar that has a bar on either side with a lower high. Several such formations are detailed on this chart.

Chart created with TradeStation® 2000i by Omega Research, Inc.

In the ellipse near the upper left corner of the chart there are two Category 1 resistance patterns. Note first of all that the resistance points in question are marked with a black dot that appears directly above the high of the highest bar in the three-bar formation. Note also that bar 2, whose high is the actual resistance point, has a high that is higher than the high of the bar immediately preceding and is higher than the high of the bar immediately following this bar. Thus, our three-bar resistance pattern is complete.

In each case of resistance formation as highlighted by the gray ellipses on the chart, the selling pressure from market participants was of sufficient significance to send the market lower. Focus initially on the first three-bar pattern of the first gray ellipse. Our formation begins as bar 1 opens slightly below the close of the previous bar and rallies sharply This rally nearly erases all of the losses in the market recorded by the previous bar. Bar 2 opens sharply higher but runs into resistance as formed by the highs of two of the three previous bars. For a variety of reasons, either technical or fundamental, significant selling is taking place in the area of the high of bar 2 in our designated formation. The



selling pressure is great enough at this point not only to establish the high of bar 2 but also to limit the eventual high of bar 3. Bar 3 opens slightly lower than the close of bar 2 and then begins to trade higher. Selling pressure in the market dominates once again, driving bar 3 to a weak close near the low of the range of the entire bar.

Note on the chart the manner in which the market respects these areas of resistance as the market trades lower for several minutes after the first two formations are completed. Also note the formation of a third resistance area as the market attempts a correction of the downtrend. The fourth formation, while still valid, comes near enough to the end of the day to be of little significance.

Note that the black dots above the bars clearly delineate successively lower resistance points above the market. The actual resistance point defined by this method is the high of the center bar of the formation, not the price level at which the dot appears. These points will prove to be vital in our assessment of both entry and exit points as our discussion of the actual placement of orders evolves in a later chapter.

support

Figure 7.2 represents several Category 1 support points as highlighted. Note that in each case the actual support point is marked by a small black dot immediately below the low of the bar. As was the case with Category 1 resistance, the bar of significance in this formation must be preceded and trailed by a bar with specific properties. In this case, the bar preceding the low bar of the formation must have a low that is higher than the low of the bar representing the actual low point of the support formation. Also, the bar following the low bar must have a higher low than the low bar. In each case in Figure 7.2 note that each bar in each formation is labeled, with bar 2 representing the pivotal bar in all formations.

The second, third, and fourth ellipses in the chart highlight areas made up of two Category 1 support areas that are merged into a multiple support formation. Note that in two cases bar 3 of the first formation also serves as bar 1 of the second formation in the set. Although these multiple Category 1 formations are a bit more difficult to recognize at first without the computer-enhanced charts shown in this figure, they are usually a more significant support pattern than a single such occurrence.

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Figure 7.2 Category 1 support is the opposite formation of Category 1 resistance, as the support point must be surrounded with single bars that display higher lows. These points are of significant importance as considerable buying must take place hereto create these formations. Chart created with TradeStation® 2000i by Omega Research, Inc.

Category 2 Support and Resistance

support

Category 2 support is simply defined as a low point on a chart where significant buying has been present for a period of time.

To pinpoint this particular support level we must recognize two separate, simple patterns. First, the two bars prior to our support

level must have two lows that are higher than the low of the bar that is our Category 2 support level. Additionally, there must be two bars following our support point that have lows higher than the low of the bar pinpointing Category 2 support. Obviously, the name "Category 2" is derived from the fact that two bars before and after the support point are required for its formation.

Referring to Figure 7.3, first notice that each bar that makes up the chart pattern in question appears as a heavier bar. Additionally, the support point in this example is marked by a small black dot below the lowest bar that appears in the darkened ellipse on the chart.



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Category 2 Support

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Figure 7.3 Category 2 support is formed when the Ion of a bar is flanked on either side bybarsthathave higher lows. The low of bar 3 i" eacn formation IS the actual support point used for order or trailing stop placement. Chart created with TradeStation® 2000i by Omega Research, Inc.

The value of the low of this bar will be used later to define precisely entry points for our trades. This bar is marked as the number 3 bar in this five-bar chart pattern. Also notice that bars 1 and 2, which appear prior to our support bar, both have lows that are higher than the low of bar number 3, our support bar. Next, observe that bars 4 and 5 which follow our support bar, also have lows that are higher than the low of bar 3. This is all that is necessary to complete the formation of a Category 2 support point. Incidentally, you may notice that, on two of the formations, bars 1 and 2 as well as bars 4 and 5 have highs that are also higher than bar number 3. Although this will often be the case, these higher highs are not necessary for the completion of our supportive chart pattern.

To illustrate this point, refer to Figure 7.4, which displays several additional Category 2 support patterns. Note that, in the highlighted pattern labeled Support Point #3, the high of the support bar is greater than or equal to all but one of the bars in the five-bar chart pattern. Obviously, the low of the support bar is below all other lows in the pattern, thus qualifying this pattern as Category 2 support. The emphasis here is to illustrate that this type of pattern is as valid

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Support Point #1

Category 2 Support

support Point #2 :

support Point

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Figure 7.4 Support points sucb as these are used for the placementofstops to enter the market. Note the acceleration in market movement that occurs when the first two support points are violated. Sell stops placed at the level of points #1 and #2 allow thetraderto enter the market automatically when these accelerations begin.

Chart created with TradeStation® 2000i by Omega Research, Inc.

as the pattern in Figure 7.3 in which the highs of the preceding and following bars were also higher than the high of the support bar. Although you will observe many more support areas that resemble the pattern in Figure 7.3, be aware that both illustrations of Category 2 support demonstrated in these two figures are equally important when support is to be measured on any bar chart.

Incidentally, you will notice on both Figures 7.3 and 7.4 that the highlighted Category 2 support patterns are followed in relatively short succession by additional identical chart formations. You will observe this sequence quite often when you begin to assess support and resistance as a significant segment of your routine chart analysis. Several such patterns in close proximity such as illustrated in the accompanying figures without an intervening resistance point should be viewed by the chart analyst as additional evidence that major support is developing in this area of the market. Recalling our discussion in Chapter 3, "People, Prices, Personalities, and Probabilities," concerning the market forces that actually cause support and resistance areas to develop



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