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Distinguishing Reversals from Corrections (3)
Tests of Major Support and Resistance

2) The second type of event to be watched for / acted upon is a test of Major Support or Major Resistance.

If long or aside: reverse to / sell short on a test of Major resistance. If short or aside: reverse to / buy long on a test of Major support.

Obviously "Major" needs to be defined, see below.

Incidentally you are "Long" something (a stock, currency or whatever) if you have either bought and paid for it (entirely or partially) or have promised to buy it at a future date at a specified price. You are "short" something which you have promised to deliver at a specified future date in exchange for a specified price.

If you buy a house and take out a mortgage you are long property and short cash. (This is usually but not necessarily a good position to be in).

"Major" supports and resistances are previous market turning-points separated from the current price-action by at least two intervening reversals.

Major Resistance

Sell short a test of major resistance of the type shown above, with a "re-reverse stop" just over a "normal" period's range above the old high. (if the chart were inverted it would be support to be bought, naturally).

Not infrequently, the market will go straight through the resistance, and you will be "Stopped-out" within a very few time periods. This is extremely irritating and expensive. On the other hand, it is astonishing how often markets will test and reverse from "Major" levels of this type, in which case you are positioned to profit from the entire ensuing down-move.

The really critical point, however, is this: If you do not sell the test of the resistance but stay long and "wait to see" whether the market goes through the resistance where do you place your stop ? (to get out of your current long position if any and to join the move on the short side). Casual inspection of the chart shows that, since a new down-trend will not have been "confirmed" until either at least one level of support has been taken out or a new (lower) high has been formed, at least one-third, more likely a half, of the previous up-move will have been re-traced before you enter your short position. At this point a significant proportion (possibly all) the unrealised profit on the up-move will have been eroded, and a significant proportion of the new down-move missed and the logical place for the protective stop on the new short position will be a long way from the entry-price.

Selling the above market short can be a gut-wrenching thing to do: particularly if you are watching the news and all the commentators are explaining why the market is going through the roof (which they invariably are at extremities). It becomes even more difficult if you have done the same thing before and been stopped-out for a significant loss almost before putting down the 'phone. It is nevertheless the right thing to do because buying and selling at probable extremities maximises the ratio of average profit to average loss.

It is noticeable that most analysts concentrate their attention on attempting to identify the direction of the next move correctly (intending to maximise the frequency of profits compared to the frequency of losses). It is, however, at least as important to maximise the ratio of average profit to average loss. If that means taking occasional additional (relatively small) losses (and possibly feeling like a fool in the process), then so be it.

To repeat the definition of what constitutes "Major" support and resistance:

"Major supports and resistances are previous market turning-points separated from the current price-action by at least two intervening reversals."

The example given above was obvious in that there were numerous minor reversals between the major resistance and its current re-test. It is less obvious, however, when there are only two:

Major Resistance -2

Answer: The three-wave move down from the top (ie two down-moves with one intervening upward correction) may simply be a now-complete correction of the preceding up-move, in which case the market is destined to reverse up from here and go straight through to new highs. This type of three-wave correction is extremely common.

But: it is at least as likely that it is either the start of a more extended and complex (and tradeable) form of correction or the start of a new down-move which is destined to continue without a significant rally for some time.

Next, Trading Strategy - tests of major support and resistance. Go there
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