Support or Resistance Trading

Horizontal support or resistance trading is my favorite style of trading. The market doesn’t know diagonals. It remembers price levels, which is why horizontal support or resistance lines make sense, but diagonal trend lines are subjective and open to self-deception. I therefore avoid trend lines because, in my opinion, they are wildly subjective and result in wishful thinking and self-deception. In fact, trend lines are among the most deceptive of all tools. You can draw a trend line across the prices or zones in a way that can change its slope and its message. If you’re in a mood to buy, for example, you can draw your trend line somehow steeper.
After making thousands of trades and looking at thousands of charts, I’ve come to the conclusion that the market doesn’t know diagonals. It remembers price levels, which is why horizontal support or resistance lines make sense, but diagonal trend lines are subjective and open to self-deception.
Support is a price level where buying is strong enough to interrupt or reverse a downtrend. When a downtrend hits support, it bounces like a diver who hits the bottom of the ocean and then automatically pushes away from it. Support is represented on a chart by a horizontal line connecting two or more bottoms (see the figure below).
Resistance is a price level where selling is strong enough to interrupt or reverse an uptrend. When an uptrend hits resistance, it acts like a person who hits their head on a branch while climbing a tree - they stop and might even tumble down. Resistance is represented on a chart by a horizontal line connecting two or more tops.
Minor support or resistance causes trends to pause, while major support or resistance causes them to reverse. Traders buy at support and sell at resistance, making their effectiveness a self-fulfilling prophecy.
Using this method, every morning I shortlist the stocks that I would like to trade based on the criteria I set forth in Chapter 4: a stock that has fundamental catalysts such as news, an extreme earnings report or a new drug approval. These stocks are the ones that retail traders are watching and planning to trade.
Before the market opens, I go back to the daily charts and find price levels that have been shown in the past to be critical. Finding price support or resistance levels is tricky and requires trading experience. If you watch me trading every morning, you will see how I place my support or resistance lines on my Alpha Predators.
For example, let’s take a look at a SCTY daily chart without support or resistance lines and another including the lines.


Example of a Support or Resistance Strategy on SCTY daily chart.
Support or resistance lines in daily charts are not always easy to find, and at times you will not be able to draw anything clear. If I cannot see anything clear, I don’t have to draw anything. There is a good chance that other traders will also not see these lines clearly and therefore there is no point in forcing myself to draw support or resistance lines. In that case, I will plan my trades based on the VWAP or Moving Averages or chart patterns that I earlier discussed.
Here are some hints for drawing support or resistance lines:
  1. You will usually see indecision candles (Chapter 6) in the area of support or resistance because that is where buyers and sellers are closely fighting each other.
  2. Half-dollars and whole dollars usually act at a support or resistance level. If you don’t find a support or resistance line around these numbers on daily charts, remember that in intraday these numbers can act as an invisible support or resistance line.
  3. You should always look at the recent data to draw lines.
  4. The more of a line that is touching price lines, the more that the line is a better support or resistance and has more value. Give that line more emphasis.
  5. Only the support or resistance lines in the current price range are important. If the price of the stock is currently $20, there is no point in finding support or resistance lines in the region when it was $40. It is unlikely that the stock will move and reach that area. Find only the support or resistance area that is close to your day trading range.
  6. Support or resistance lines are actually an “area” and not exact numbers. For example, when you find an area around $19.69 as a support line, you must expect price action movement around that number but not at exactly $19.69. Depending on the price of the stock, an area of 5 to 10 cents is safe to assume. In the example with a support line of $19.69, the real support area might be anything from $19.62 to $19.72.
  7. The price must have a clear bounce from that level. If you are not certain if the price has bounced in that level, then it is probably not a support or resistance level.
  8. For day trading, it is better to draw support or resistance lines across the extreme prices rather than across areas where the bulk of the bars stopped. This is the complete opposite of swing trading. For swing trading, you need to draw support or resistance lines across the edges of congestion areas where the bulk of the bars stopped rather than across the extreme prices.
Placing support or resistance lines, although tricky, is actually quite simple once you get the hang of it.
Let’s review a recent trade that I took based on these lines. CarMax (ticker: KMX), the United States' largest used-car retailer, on June 21, 2016 had extreme earnings and its stock gapped down over 3%. That was a perfect opportunity for retail traders like me to find a good trade plan. I quickly found the support or resistance area level on a daily chart and watched the price action around those levels.

My watch list Gapper on June 21, 2016 at 9:20 a.m. KMX is an Alpha Predator for that day.

KMX support or resistance lines and my trade for that day.
After reviewing the daily charts, I found two levels of $48.09 and $48.48. When the market opened, I watched the stock and realized that the area of around 48.09 acted as a support. When I saw an indecision candle around the support line, I purchased 1,000 shares of KMX with a stop of below $48. The stock surged up toward the next level at $48.48 and, interestingly enough, $48.48 was also close to my invisible half-round number ($48.50). I sold half of my position for a profit and kept the balance for going higher. Since I did not have any other support or resistance area higher up, I decided to sell my remaining position at the invisible resistance line of $49. As you can see, $49 acted as a strong resistance line, and the stock sold off from that level.
To summarize my trading strategy for support or resistance trading:
  1. Each morning, when I make my watch list for the day, I quickly look at the daily charts for my watch list and find the area of support or resistance.
  2. I monitor the price action around those areas on a 5-minute chart. If an indecision candle forms around that area, that is the confirmation of the level and I enter the trade. I usually buy as close as possible to minimize my risk. Stop would be a break and a close 5-minute chart under support or resistance level.
  3. I will take profit near the next support or resistance level.
  4. I keep the trade open until I hit my profit target or I reach a new support or resistance level.
  5. I usually sell half-positions near the profit target or support or resistance level and move my stop up to my entry point for break-even.
  6. If there are no next obvious support or resistance levels, I will consider closing my trade at or near half-dollar or round-dollar levels.
A similar approach will also work when you short a stock.