A Look at Support and Resistance in the Wake of the Plunge

I’d like to take a technical look at what has happened in the stock market in the last week, and give you a market technician’s interpretation. Remember technicians derive their interpretations of events based primarily on price action, and also upon the action of other various indicators. The key word is action, because by looking at the market action, we can see what the market is telling us (and boy has it been active). Through its actions the market speaks to us everyday if only we will listen. This price action is believed to be the direct result of the forces of supply and demand working themselves out in the exchanges and around the world.

 

Below is an hourly chart of the S&P Depository Receipt (SPY). You can see that the SPY failed to reach its previous highs at A. with no new highs after July 24. This is a warning sign but not a sell signal. Perhaps it might mean we could be in for a minor consolidation before the trend resumes, or potentially a trend reversal. Towards the end of July the failure to meet and exceed the previous highs becomes more apparent as prices approach the lows at levels reached in mid-July, namely around the 130 mark. Watching action at these levels then becomes critical, since the 130 level in the SPY has acted as support recently. If the trend is still higher, we would expect these lows to hold and function as support.

 

 

You can see right towards the end of July that there was a small battle between the bulls and bears right on that 130 level. Remember at this point you should just be watching and waiting for downside confirmation, as there is a slight bearish bias in the chart as you can see that 13 period rate of change, or ROC (in this case 2 day ROC since there are 6 ½ hours in a market day), has turned negative in a downtrend. The action pierced through the 130 level on the 29th of July, giving a slight indication that support is more likely to break than to hold. Once that level was pierced for good on the 1st of August, the downtrend begins in earnest. Why? And how could you profit from this?

 

Technicians use support and resistance as part of their analysis. It is one of the essential elements of technical analysis, the others being price action and volume. Like traitors in a war, support and resistance frequently switch sides as prior support becomes resistance and prior resistance becomes support once they are breached. This is one of the fundamental principles of support and resistance. There is a logic and theory as to why this is the case, but for now you just need to know that it is one of the deepest principles inherent to S & R.

 

You can see from the chart that once the 130 support level is decisively broken, there is no looking back. The support that once was is lost as it becomes ceiling instead of the floor. This acts as an intermediate sell signal for those holding long positions and creates an excellent risk/reward scenario on the short side. By going short right under the 130 level, traders and investors can risk only a couple points of downside, since the return of prices above the S/R level would indicate a false move down. For example a trader putting on an S&P short at 129 might close his/her position if SPY hits 131 and go long, since the 130 level is key. But as we know, that was not the case.

 

This combination of selling longs and initiating shorts has the capacity to initiate a major downtrend as support levels are taken out not just in the averages but in every individual stock as well. Keep in mind that these S&R levels are never exact, but are more generally perceived as zones. If the level is around 130, it may actually be from 129 to 131, or anywhere more or less than that depending on the volatility of the stock. The more traditionally volatile a stock, the more S&R is less likely to be exact.

 

It is important to note that the longer a support or resistance line has taken to build, and the more number of touches, the stronger the effect becomes once the line is broken. You can see on the chart below of the financial sector that support developed over a two month period, with about ten touches of the line during that time. This line can also be viewed in the context of a descending triangle pattern – a usually bearish continuation pattern. Once this level was decisively broken (and the triangle broken out of to the downside), the fallout was tremendous to say the least. An astute investor may have sold his financial commitments on the 2nd of August, and a trader may have initiated his shorts.

 

Daily chart of 3X Financial Bull

 

Underneath the chart of FAS is relative performance of the issue compared against the S&P. Well before the breakdown of support, you can see that the FAS was in a downtrend of underperformance against the S&P, indicating relative weakness in the financial sector. Keeping an eye on this, and keeping it in mind, was a clear signal to mind your financial investments, or not initiate new ones during this time. A trader sees this as an excellent setup for going short, once support is broken. (Which can be done through short financial ETF’s: FAZ, SKF, SEF, among others)

 

These are just a few of the ways that you can use technical analysis no matter what your investment goals and risk appetite are. As you can see, technical analysis is critical in determining entries and exits and minimizing your risk because it makes sense of specific prices and what the market is saying about your investments. It doesn’t matter if you analyze shares of individual companies or of sectors or averages because the principles of analysis are the same. The only question is… will you be able to correctly interpret what the action is dictating?