Option Investor
Trader's Corner

Finding Support & Resistance

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"Your support/resistance predictions have been very helpful to me in my index options trading. If you could tell me more about how you arrive at these numbers, I'd like to learn more about your methods!

This general subject, of how to find support and resistance levels on charts, also requires some discussion about being aware of prior lows and highs, potential resistance or support at certain key moving average (e.g., 21, 50 and 200-day averages), drawing trendlines, following trend retracements, moving average envelopes and constructing price channels.

There is a combination of things or tools that I use to try to figure support and resistance areas. First let me address the question of then trying to predict at which of these points an Index might turn or reverse trend.

I like to buy Index calls and puts especially, where it's like paying wholesale for the option and not retail. That is, anticipating WHERE the market will most likely TURN (i.e., reverse) and buying calls just at where you think significant support will be and just at where you assess significant resistance. This method attempts to pick tops and bottoms before its clear that they are going to be that. And, different than "trend following" techniques, where you watch for clear signs of price momentum in a new direction before taking a trade.

HOWEVER, if your skill and analysis are sound, these support and resistance points will be where:
1. Premiums are cheap as the market trend hasn't reversed (yet).
2. It doesn't "cost" as much if you're wrong - why? Because you can exit just below or above your projected support or resistance point, when the projected support/resistance levels are penetrated.

I also tend to go out at least a few weeks in terms of expiration
and to stay more or less at the money (ATM) in terms of strike. I may not go as far as 2-3 months out, but am usually wanting to go beyond the current month's expiration if I think that a trend reversal will be pretty big this depends on a method or ability to ANTICIPATE support and resistance.

The greatest option trader I ever knew, Mark Weinstein (not the
writer, rather a very private trader) - a complete unknown except for being in Jack Schwager's "Market Wizards" book. He had the kind of confidence I am speaking about as far picking buy points ahead of where the market reversed. And, this trader taught me that, for catching the bigger moves, it was necessary to anticipate areas to buy options before the crowd bought them and the market makers jacked the premiums way up.

It's a well-known style or theory and one even Warren Buffet uses so well - buy em when no one wants em or when the world isn't looking at the thing.

Getting back to the "how to" aspect - there are a few different things that I use in the way of indicators or patterns and chart examples follow

This seems almost too obvious, but it's amazing how many traders lose track of a prior significant high or low. What makes prior lows or highs "significant" is that such prior highs or lows were reversal points; e.g., after the high point of the last advance, the trend turned down after that, but some weeks later prices have climbed back to near the prior price peak.

Anyway, number one on the checklist so to speak to keep aware of where key prior lows or highs ARE and recognize that certain prior lows will be strong areas of buying interest (support) and certain prior highs strong areas of selling interest (resistance).

A case in point is provided by today's daily chart of the S&P 500 Index (SPX)

The prior low of significance was made in January in the 1165 area and, so far, a rebound has developed from just this price area, after being reached in late-March.

Assuming that this prior 1165 low was going to "hold" and a low was going to again form in the same price area, I bought S&P May calls (many traders would have bought April's) and set as an initial getting out/exit point as 1157.

I could have risked initially to just 1160, but that level also represents the 50% retracement level of the Oct March advance and SPX may yet test or fall to the 1160 area; or, a bit lower, to the up trendline coming up through the October low. (Of course, this trendline will intersect at a higher level over time due to its slope.) For this much "risk" I assessed "reward" (upside) potential for the Index as back up to 1200. Risk 7, potential to make 30 points. Good risk to reward.

A high potential area for the market to find support, or hit resistance, is at a trendline (i.e., a straight line drawn through at least 2-3 lows or 2-3 highs. Especially so, when a correction is more "technical" in nature; e.g., the market got overextended and stocks are being sold that got overvalued and would be buyers are backing off from doing new buying until valuations get cheaper again.

In early-March the S&P trend was still up and the fundamentals probably not all that different from prior weeks. However, the rally back to the trendline, drawn through the prior peaks, signaled resistance at 586. Use of trendlines is sometimes the best way to anticipate a reversal point, as can be seen below in the S&P 100 (OEX) daily chart at the downside reversal of early-March

Of course, most of the time we use the up trendline to determine potential support on pullbacks

On the left hand side of the QQQQ Weekly chart below, the third low, within the yellow circle, established the stock's up trendline in 2003. Subsequent pullbacks to this bullish up trendline, at the green arrows, were points to buy. Moreover, use of the trendline created a method to exit the stock when it got pierced. The concept of the "trailing stop" is based on the idea that you follow a trendline higher by raising your sell stop exit point to just below the trendline.

Conversely, the exiting sell "signal" came after the trendline no longer coincided with support and buying interest as happened finally in late February of last year (2004). The down trendline that got established by connecting the Jan July highs was tentatively figured to define a falling resistance. The breakout above the trend (at the down red arrow) was a signal to exit any short or put positions.

There is an art to drawing trendlines. Draw them though 2-3 lows or highs and through the MOST number of points - don't worry about the basic charting concept about only using the lowest low and the highest high always.

The thing with trendlines is that you need to develop some faith that they "work" more often than not - it's not that you have the attitude that I will believe it when I see it - waiting until there is a strong recovery rally will mean that the option will not be as cheap. That's ok too, but this is my style and I have developed some confidence in trendlines, especially coupled with other technical patterns.

It helps when you see 2 or 3 days worth of highs or lows in the area of a prior high or low; or, at trendline

There are a few lows made, so far, in the 10,400 area of the Dow 30 (INDU) and this is providing an idea that a double bottom could be setting up.

Use em! If an Index or a stock for that matter retraces around half of what it gained on the last rally, a 50% giveback is about all it will typically give back before reversing back to the upside in an uptrend - the exact reverse in a downtrend.

You'll notice in the daily chart of the Nasdaq 100 (NDX) below, that the index has fallen under its prior low of January, but is so far holding in the area of its 50% retracement.

The first down arrow above points to a second high made in the 1150 area in NDX, which activates the prior high rule.

In this example above with the NDX chart, its apparent that buying interest is coming in when the index has made approximately (not always exactly) this one half retracement of the last major advance. This is an area of perceived value.

I wrote about so-called "Fibonacci" retracements more in depth in my LAST week's Trader's Corner article which can be viewed again by clicking here.

Moving averages and moving average envelope lines often highlight support and resistance, especially the 21, 50 and 200-day moving averages in stocks and stock indexes.

The point with moving average envelopes is also that there is some "art" in using them and part of that is knowing that they give not only an idea of when the market is extended, such as on the downside, but what that price area might be based on prior history of volatility or range.

Why did I have the lower envelope percentage set so that the lower and upper lines were set to represent the price always 4.5% above or below the 21-day moving average? As above (often), so

When, in an uptrend, daily highs are tracking a moving average envelope line that is 3%, such as in the S&P 500 (SPX) or 4.5%, appropriate for the more volatile Nasdaq Composite (COMP), I often assume that in a good-sized correction, the lows will also reach that same extreme as at the peaks.

Of course, a downtrend can just follow this line lower and it does not necessarily mark a reversal point. Again, look at both this and other indicators for further clues. At a minimum I often figure that a first rally will take the Index back up to the 21-day moving average.

It's apparent in the COMP chart above that the 21-day average often coincided with support and resistance. Sometimes, the same with the 2oo-day moving average.

You may have noticed in my Index Trader commentaries that I often work with trendline channels, both on hourly and daily charts. What you can see on the daily chart is what you can also see on the hourly charts, only in better detail.

It's a tip off to buying developing or emerging buying interest when lows start being made repeatedly in the same area. And when that area is also at the lower boundary of a trend channel or a single trendline that intersects 2-3 or more lows. The upper channel line is simply the parallel line to the lower one in this example of the S&P 100 hourly chart below -

I'll go into the technique of drawing trend channels in my next Trader's Corner.

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

Good Trading Success!!

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