Support and Resistance and Breakouts
Think of security prices as a war. It is a battle between a bull (the
buyer) and a bear (the seller). The bulls push prices higher and the bears
push prices lower. A buyer that feels an area has good value, will buy at
that level. The seller that feels that a stock has reached fair value, will
sell at that higher fair value price. The direction prices actually move
reveals who has won the battle.
Remember when a trade takes place, a buyer and seller agreed to a price.
There was a buyer and a seller involved in the transaction. The buyer feels
the stock will go up. The seller wants to move on to another stock that he
may feel will appreciate faster.
Support levels are the price where the majority of traders feel the value is
a good buy.
Resistance is the level in which the majority of traders feel prices will
move lower.
When the majority of traders and investors change their expectations, these
support and resistance areas get violated and a new trend may be beginning.
This can occur due to changes in expectation of earnings, new product
development, change of personnel, cut backs or expansions.
One interesting pattern that traders see after a breakout, is that the stock
or index retraces a part of the initial move by about 50%. If the 50%
retracement does not hold, the stock or index can still be in a trend if the
previous breakout resistance holds.
Let look at an example of a potential breakdown in Yahoo! Inc.
(NASDAQ: YHOO).
One important lesson I have learned is that the stronger stocks tend to stay
stronger and the weaker stocks tend to get weaker.
On Tuesday, we had a major sell off in many NASDAQ and Internet stocks.
Many stocks have recovered partially from the lows of Tuesday and a few have
even moved on to make new highs.
However, many stocks are still lingering near weekly, monthly, or yearly
lows.
One stock that did not rebound very well is YHOO.
During the sell off Tuesday April 4, 2000, YHOO dropped to a low of 132. A
recovery brought YHOO back to 171 late Tuesday. On Wednesday and Thursday
while many stocks in the NASDAQ continued to move higher and retrace their
sharp sell offs, YHOO struggled.
By Friday’s close, YHOO was back at Thursday’s support level.
If YHOO breaks below 150 Monday morning, it may go back to test 132 or even
lower.
I would exit any longs in YHOO on any trade below 150.
An aggressive trader may want to short YHOO at 150.
If shorted, I would place a stop at 156.
IF YHOO opens up strong on Monday morning, do NOT exit or short the stock.
The 150 could be support that holds.
