Understanding Support and Resistance By Ed Mendez ---------------------------------------------- Taken from The Active Investor, James Dicks E-Newsletter, January 2005, www.jamesdicks.com ---------------------------------------------- Support and resistance are used to predict the possible range a financial instrument may have for the particular time frame being used by the trader. Many professional traders use this calculation as a guideline for entry and exit, while others keep these numbers handy to know what technical traders are doing, and either get out of their way or try to ride their coattails. The knowledge of using these numbers came from the futures trading pits for day-trading purposes, and has been around for many years. This technique works best in markets that have wide daily trading ranges (beta) like the NASDAQ and the FOREX. I have also run the formulas on stocks with high betas in the NYSE and AMEX exchanges. On exchanges, if it is working for that particular stock, then ok, but you have to remember each stock has its own specialist in these exchanges who really doesn’t care about support or resistance numbers. They work orders as they come in from institutions and floor traders. But in the NASDAQ, it is more reliable since the stocks are usually more volatile and there are a lot of technical traders with no specialist to deal with. Also, you can look into trading the NASDAQ 100 Index (QQQQ) instead of individual stocks so you don’t get caught up in a market makers game of chasing, holding or controlling a stock to manipulate a price level they need.The basis of this type of trading consists of five arithmetic formulas that are part of the basics of technical analysis. The pivot is used to derive support and resistance levels. Take a look: P= (H+L+C)/3 P=Pivot, H=High, L=Low, C=Close R2=P+ (H-L) R2=Resistance Level 2 R1=P+ (P-L) R1=Resistance Level 1 S1=P-(H-P) S1=Support Level 1 S2=P-(H-L) S2=Support Level 2 The idea here is that you want to be long above the pivot and short below the pivot. Resistance level 1 is the first level we would expect the market to meet resistance in a bull rally (long buying). This is where the first selling should appear in a rallying or up market, and it would be our profit objective if we got long. The market can and does penetrate resistance points, but this is the first level of resistance. If using a trailing stop-loss to protect our long position and the market met R1, we can sell out and cancel the stop. We can also consider entering into a short at this time. But if it broke above R1, you could move that stop order above R1 to maintain the long and keep profiting. R1 now becomes S1. R2 (which would now become R1) is the last point you would expect resistance to come into a rising market. That is, we don’t want to be short when the market violates R2. Of course, level 1 and 2 supports (S1&S2) work the same way in the opposite direction, for example, if you are short. You can enter the market around support and resistance levels as they are reached; that’s why you figured them out and what they are for. If you use PremiereTradeTM AI, the software figures support and resistance levels out for you within seconds. But in the end, it is a judgment call on your part and you should definitely know your stock or financial instrument’s characteristics, to avoid surprises. Remember, different markets call for different stops, so make sure you adjust accordingly.