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Support and Resistance

The Simple Key to Winning Trades

Written by Steve Christ
Posted January 22, 2009 at 7:31PM

With one hand on the bible and the other raised high, Barack Hussein Obama began his first day of work on Tuesday afternoon. And in a moment that belies its greatness, power changed hands in America again without so much as a single shot.

The Hatfields and the McCoys had, for the most part, taken the day off.

And except for a shameful heckling of the former President and his staff, Tuesday was a picture of a country at it best as it handed over the reins of power.

But while the millions on the mall cheered, there was no such truce on Wall Street. The bears were working over the bulls and had grabbed the upper hand. Instead of hope, they peddled fear.

As a result, the Dow began to drop from practically the first words out of the new President's mouth. And by day's end, banking worries had pushed the Dow down 4%, notching the worst inauguration day performance in history.

That left everyone wondering the same old political and economic question as the financial storm President Obama alluded to in his speech raged on. The question, of course, was a giant "Now what?"—which at this point makes the $64,000 question seem like so much chump change.

Up...down...left...right....who knows exactly how the Obama presidency will move the bulls and bears?

In the meantime, however, while the world waits to see what direction the new administration will take, the broader markets are without a doubt trapped in trading range. It seems they can't decide which way to turn either.

That's where an understanding of key levels of support and resistance becomes critical to traders gauging the market's every move.

Understanding its basics is often the difference between a winning and a losing trade.

What Are Key Levels of Support and Resistance?

Simply put, support and resistance are the key levels in the broader markets and individual stocks where the bulls and bears meet. It's at those levels where the direction of the market really takes shape due to the laws of supply and demand.

And if there is one thing for certain, the price of everything—be it stocks, houses, or football cards—depends solely on those forces.

In that regard, oversupply is bearish and overdemand is bullish. Conversely, when these two forces are equal prices trade within a range.

Support, then, is a price level at which prices are so low that they draw in buyers. The logic here, of course, is simple. At certain price levels the selling becomes exhausted, and buyers become more inclined to buy.

In short, it's the level where price slides typically end and buying resumes—otherwise known as a bottom.

Resistance, on the other hand, is simply the other side of the coin. It's the level where prices are so high that few buyers are willing to bid. Moreover, since it is also a level where traders are looking to sell, it creates an oversupply that eventually drives down the share price--otherwise known as a top.

Simple enough, right?

But figuring out where exactly these levels exist is often a matter akin to reading the tea leaves. However, as any technician will tell you, figuring out the future is partly a function of studying the past.

As a result, support and resistance levels can be found by studying charts and identifying general price points where the market tended to bounce or top. This can be found by studying either specific moving averages or by identifying established trend lines.

And once identified, traders simply follow those existing trends, buying at support and selling or shorting at resistance. It's the essence of buying low and selling high.

Of course, it should be noted that imaginary lines don't always hold. After all, the bulls and the bears don't give up easily. So, at certain points bears are able to push the advantage and send share prices crashing through the floor, resulting in a breakdown—something seen more than once over the last 12 months.

Conversely, resistance can also fail as the bulls push prices higher, resulting in a breakout. And when either one of these scenarios happens, the roles tend to switch. On a breakout, prior resistance levels become new support, while on a breakdown prior support levels become new resistance.

As result, these are often referred to as "key levels," since breaking them either one way or the other tends to set a whole new short term trend—either bullish or bearish.

The DOW: Hovering on Support

That brings us neatly back to the "Now what?" question as the broader markets hover over one of those key levels, making it something of a moment of truth.

As you can see from the chart, the 8000 mark on the Dow has served as support for some time now. That has driven the bears crazy, since the 8000 level has put a general floor under the market for least four months.

As a result, the markets—while volatile—have basically been trading in a range. Support has managed to hold at 8000, while resistance has kicked in numerous times at about the 9000 mark.

support


But with the Dow now walking the tightrope again to the downside, fears of "the next leg down" have tended to dominate the market chatter this week. That's because if 8000 on the Dow doesn't hold up as support here, the markets could move much lower as the bears take the upper hand.

The hope, of course, is for that bounce. For the bulls, it can't come soon enough.

Either way, recognizing where these key levels exist is often the difference between buying at the top and selling at the bottom.

Use them to your advantage.

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director
The Wealth Advisory

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