Support, 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's look at an example of a potential breakdown in Apple Computer
(NASDAQ: AAPL).
One important lesson I have learned is that the stronger stocks tend to stay
stronger and the weaker stocks tend to get weaker.
The week ending June 2, 2000 saw the NASDAQ gain 19% and on Friday June 2,
2000 an explosive gain in many stocks on that day because of favorable
economic reports.
For the week ending June 9, 2000, some stocks continued their gains, while
others drafted lower back towards the prices the stocks where trading at on
June 1 before the big gain.
What do you think people who bought stocks June 1 in anticipation of further
gains will do if their stocks fall below the low of that day? I think many
have stops in below those lows and that a breakdown of those levels may
bring on selling of shares bought last week and even some new selling on
those issues of disenchanted longs.
AAPL is another example of a stock that fits the pattern I just described.
On June 1, AAPL closed at 89 1/8.
On June 2, 2000, AAPL hit a high and over the past week or so, AAPL has been
in a consolidation pattern.
However, AAPL is at the lower end of the range. Perhaps this is support in
the stock and the stock will move higher. However, as it stands now, there
are many new buyers who I believe will exit their position in AAPL if it
breaks this support at 91.
If AAPL breaks 91 in the morning, I would exit longs.
An aggressive trader may want to consider a short at 91 on Sell Stop Short.
I do not like tests of support. Usually stocks breaking multiple tests of
support do very poorly once that support is broken.
On the other hand, even if AAPL moves up from here, it will have selling
resistance all the way up to 99.
If a short is entered, place a stop 93 �.
There many stocks that looks like this AAPL chart. Be aware of support and
resistance levels in your stocks.
