back start next
[start]                  [ 18 ]                                  
dramatically. Combining this process with the Directional Day Filter will further increase trading accuracy.
This being said, lets preface our remarks concerning this with a general discussion of the dynamics of this pivotal concept. P0ln Visualize for a moment that market prices and charting are nothing more than the graphic representation of human activity in the marketplace. Markets move higher when there are more buyers than sellers. Markets move lower when there are more sellers than buyers.
Lets assume for the purposes of illustration that there is one large trader or a group of traders who for whatever reason wish to purchase as many shares of their favorite stock as possible at a given price. They patiently bide their time until the market drops to their desired level and begin their buying activity. This buying activity drives the market a bit higher for a while, moving the price to a higher level than our traders are willing to pay. A bit of selling surfaces as our guys lie low for a while and the market drifts lower, back into our groups buying zone. They once again buy the stock until it rises out of their range. This can happen multiple times. Eventually, the market realizes there is significant buying activity in the market at a certain level. Other players come aboard, fueling the rally.
The level at which all the buying in this example occurred is referred to as support. This is a price at which our group of traders decided to buy, or support the market.
The exact opposite can occur when our group of hypothetical traders decides to sell at a certain level, selling in volume each time the market rises to a given point. In this case we refer to this point as resistance, a point at which the forces of the market, in this case our group of traders, cause the market to move lower.
The market is quick to identify these points as the activity around these levels can be very useful in predicting near term-market movement.
When the market breaks through one of our defined support or resistance points, price movement can be significantly accelerated in the direction of the breakout. Think about this phenomenon again as a function of human behavior.
Back to our little group of traders. They are buying at a given level, and the price continues to return back down to their level. Everything has a limit, including these guys trading accounts so they must discontinue purchasing and wait for the expected rise in
price. However, a larger group of traders has noticed a substantial accumulation of shares at a given price; they know there will be substantial selling if they can force the market down through this price level and spook our first bunch into throwing in the towel. Due to their market observation experience, they are aware that most long positions will have stop loss protection in place in the form of sell stops. These are resting orders that become market orders when the price of the stock issue trades at the stop price. Experience also tells others in the market where these stop levels are likely to be resting in reference to the buying level that has created the market support now evident. Usually, these stop levels are only slightly below market support. The second group knows there is a prize to be won if only they can be successful in driving the price of the stock down through the resting sell stops just below market support. This type of activity is known as "running the stops" and is a frequently observed phenomenon as astute market players go on fishing expeditions in search of areas of stop accumulation.
Sure enough, the selling pressure from the second group, along with the market in general, forces the market through the previous support level, triggering selling pressure as the stop orders are filled at any price. As the market continues to drift lower, traders who have not protected their positions with stop loss orders are nervously watching their equity slip away. Soon they are forced, either by fear or by margin concerns, to liquidate their substantial holdings to stem further losses. This rapid liquidation of a large number of contracts, which were accumulated over a much longer time frame, results in panic selling by others holding long positions and new sellers getting on board the new downtrend, and the market continues to work lower.
This make-believe scenario demonstrates the importance of support and resistance in the real-world markets. These points can be used as either specific buying or selling points. Traders can enter the market on the long side in the area of perceived support, assuming that the market will turn higher at that point, placing them in a profitable position. Others will take short positions in areas of market resistance, betting on a price decline from these spots to add to their trading accounts. Traded properly, these strategies can be useful. In most instances, a rather small risk can be locked in with a protective stop loss order. The area for stops to build up on the other side of support or resistance is usually close enough to create only a small loss should they be triggered.
This use of support and resistance depends on the market turning at a particular point to be effective. The trader must execute a long (or short) trade at a point and then wait for the market to respect his or her defined support (or resistance) point for the anticipated profit to develop. In other words, the position is taken in anticipation of the market respecting an important point in a specific fashion. In many respects this strategy is still dependent on a markets not yet realized reaction to a specific chart point.
The approach we will be taking with respect to the placement of entry locations around support and resistance points is a bit different.
As stated previously and demonstrated in our make-believe trading scenario, the reaction of a market when it breaks through significant support or resistance can be sudden, violent, and decisive. It is this type of activity we want to put in our trading account.
The strategy here is to place your buy orders at or slightly above market-defined resistance and place sell orders at or slightly below market support. All orders placed in this fashion are stop orders, or those that are automatically filled when the market price reaches their level. The objective is to enter the market on the front end of what could be a rather quickly developing market trend.
By placing our orders as described in the previous paragraph we are taking advantage of the same market scenario that was responsible for our first group of traders either being stopped out of their position or being forced to throw in the towel to prevent even further losses. The same market forces upon which our second group of traders is depending for their success will be a major factor in creating a profit for our position. As the market breaks through the support created by the buying activity of our first group of traders, our short position is automatically filled, enabling us to profit from the market decline propelled by more stop loss selling. Additionally, the establishment of new short positions by those who are only now realizing that there has indeed been a change in market trend will add further impetus to the decline in price.
Obviously, this scenario on the short side of the market will be easier to execute in the futures arena than in the markets that deal with individual stocks due to the uptick rule, which allows a stock to be shorted only on a price greater than the previous price. However, prices in any market rarely move in a straight line in any direction. The frequent pullbacks in price due to normal market activity pro-
vide opportunities to enter short positions in accordance with exchange rules.
Often, when examining a successful trade generated by this use of support and resistance points, a question arises: Why wait so long to enter the trade since we could have sold it much higher, since we knew the support was going to break anyway?
The short answer is rather simple. Although its obvious from a historical charting perspective that our trade was profitable and would have been even more so had we entered prior to the break of market support, in real time we dont have that luxury. The likelihood obviously exists that the market will indeed respect its previously established support and rocket higher from this level, creating a sudden losing position from the sale that occurred above the support point. In many respects selling at a level somewhat above support carries with it much of the same risks that are present when a long position is taken at the support level. In the case of the long position the trader is anticipating the market to respect support and turn higher. A trader establishing a short position above support does so in expectation of defined support breaking down. In both instances the trader is taking a position and then hoping that the expected market reaction will then occur.
Instead of taking a position and then hoping the market will react at the support or resistance point, isnt it a more reasonable approach to act after the market has reacted to a given situation and is therefore somewhat more predictable? In essence that is what you are accomplishing by allowing the break of a support area to trigger your trade. If the market does break support and enters you into your position, probability dictates that you have a greater than average chance to make a profit in the trade. In placing the sell order below support you are making a bet that the market will break support and then head further south. If you are wrong and the defined support in fact does support the market, spurring a rally, youre only wrong. Not less wealthy. Since the market, due to its new respect for old support, was not able to reach your preplaced stop order, you do not have a short, unprofitable position in a rising market. You simply remain on the sidelines, keeping your powder dry and your trading account intact, waiting for the next high-probability trade to surface on your chart.
Does the market always go through defined support and resistance to a degree great enough to assure us of a profit on each trade? Of course not. Many times the market will test support or resistance,
break it briefly, find no sell stops lurking in the shadows of support and then trade steadily against the new position established by the just-activated stop order. Stop losses are always necessary to guard your account against this possible outcome of the trade.
It therefore becomes of prime importance to the technical trader to do everything possible to tilt the table in his or her direction. Obviously, the decision of around which support point to set a trap is critical to high-percentage trading. It is accordingly as important to know on which side of the fence to plant the trap. For this purpose in our developing strategy we will incorporate two basic tools to give us that edge necessary to maintain a profitable strategy. We will use the Directional Day Filter to define the major trend of the day and a unique application of oscillator indicators to open the appropriate buy or sell windows.
Again, for emphasis, when the market breaks through one of our defined support or resistance points, price movement can be significantly accelerated in the direction of the breakout. It is for this reason we use support and resistance points for the placement of buy and sell stops. We will use some of the same charts used in the previous chapter to illustrate the effective placement of these entry stops.
This chart shown in Figure 8.1 was used earlier in the previous chapter to define Category 2 support. 1 have added three horizontal lines projecting to the right of each defined support point to demon strate the use of these points. Assuming that we have a valid sell window open from either one of our oscillator strategies and/or the Directional Day Filter, we are then in a mode of looking for a precise entry point for our short trade. As soon as the first support point labeled on the chart is available, after the formation of the last darkened bar, we will place a sell stop at or slightly below the defined point. The short position is entered as the market trades through our price, as it becomes a market order at this point.
An almost identical scenario develops shortly thereafter as a second short entry becomes possible. The next support level is broken, filling our short position order as this market continues to erode. Finally, support holds near the end of the day.
An important point arises here with respect to the third and final Category 2 support point. Although our strategy was successful in getting us into two profitable short positions, it was equally successful in keeping us from entering a third short position that would not have added to the bottom line. It would have been tempting to the undisci-
i ChdiT [ 1 ) iI)U liMteK IKiy Onlii (AST 1 i
DSPU0LAST-1 min 06/27(2000 01471.40 - .8 -0.66% l>-144 1 00 H=tl94.C0 L=1477 50 V=0
Category 2 Support Short Entry-.......
1471.00 470.00 469.00 1468 00 1467 1466 00 1486.00 1464.00 1463.00 1 482.00 1461.00 1 460.00 -1469.00
26 131 1 36 1 41 1 46 151 VSIS 2:01 2:06 2:11 2:16
Figure 8.1 Category 2 support is utilized to enter two successful short positions. The identical strategy prevented taking a third short position near the low of the illustrated move.
Chart created with TradeStation® 2000i by Omega Research, Inc.
plined trader simply to enter into a third short position since the market had been in a down mood all day and previous entries had been successful. This rush to add another short trade would not have been a profitable decision since the market now respects support and halts its decline for the day. Had we attempted to enter a third position in the same manner that had proven acceptable in the first two trades on this chart, no position would have resulted since the price did not violate our support area and activate our preplaced sell stop.
Another situation is shown in Figure 8.2. Following the establishment of a lower-trending day by the Directional Day Filter, the market forms an initial support point as marked by #1 on this Microsoft Corp. (MSFT) chart. Instead of breaking through when first approaching our support area, the market respects the support at first, in effect strengthening the existing support level by placing a second support point at a price level only slightly higher. In the process, a second Category 3 pattern appears that places additional support at this area. When the market finally does violate this support, the market continues its move lower.
[start]                  [ 18 ]