Support
and Resistance
An important
concept in the use of trendlines is that of support
and resistance. A continued trend is based on
underlying support for prices in the market, for
whatever reason. Similarly, there's resistance
to higher prices built into the market. The trendline
is one way to capture and illustrate these zones
of support and resistance.
As long
as the market stays within these zones of support
and resistance, as shown by a trendline, the trend
is sustained. Any penetration through a trendline
warns of a possible change in trend. We may not
know the reason behind such a change, but we do
know that for some reason the support or resistance
for a market is changing.
The
Rhino Theory of Support and Resistance:
The upper and lower trendlines contain the price
the way a barbed wire fence might contain a rhino.
Think of the prices as the rhino and the trendline
as a barbed wire fence. If a rhino leans against
the wire, the fence will give a bit, offering
more and more resistance until either the rhino
eases off or the wire snaps. If the rhino has
wandered along and leaned against the fence in
several places without breaking through, we will
have more faith in the strength of the fence.
If the
rhino only leaned against the fence once
before moving along, it is less meaningful. In
charting practice, a line based on one high or
one low means nothing. Two highs or lows is the
bare minimum. The more points you can connect
the more significant the resulting line. And,
the more significant the trendline, the more significant
any penetration will be. (I say will be
because all trends eventually reverse some
day!)
Round
numbers
Another
aspect of resistance and support concerns the
round numbers associated with price levels, such
as 10, 20, 25, 50, 75 and 100. Since the price
reflects the psychology of the marketplace, these
levels offer "natural boundaries or targets."
With resistance and support common along these
levels, it makes sense to avoid placing orders
right at these values. (If buying on a
short term dip in an uptrend, you'd place your
order just above an important round number). It
also makes sense to place stop loss orders below
the round numbers on long positions, rather than
exactly on the round number (i.e., $4.90 rather
than $5.00).
