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Trader's Corner

Determining Support and Resistance: As Much Art as Science

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Buy low and sell high, the television ad proclaims, but where are "low" and "high" located? That would be at support and resistance.

Some of us aren't buying low or selling high: we're trading condors or other combination plays, and we want indices or stocks to stay in a certain range. We want to establish the bull put and bear call credit spread components far enough away from the action that prices will stay away from them. That would be just the other side of important support or resistance.

Whatever we're doing as traders, we need to know where support and resistance lie.

Although other articles have dealt with locating support and resistance, including some of the weekend Trader's Corner articles, it's a subject that should be reviewed periodically. Even experienced traders sometimes like to look over the shoulder of another trader, as traders watch slightly different indicators. The list of indicators or tools that I watch most often include moving averages, trendlines, Fibonacci retracements, regression channels, nested Keltner channels and Average True Range (ATR).

Although I originally thought I could delve into all these in a single article, including charts will lengthen it so that the sub-topics need to be divided into separate articles. This one will discuss moving averages. Here's a chart that illustrates how key a moving average can be in pinpointing support. Since this article was prepared a week or two before publication, the charts do not reflect current prices.

Annotated Weekly Chart of the SPX:

Moving averages can serve as resistance just as effectively as they do as support, particularly in a declining market environment.

Most traders watch moving averages, but it's surprising how different the preferred averages might be from trader to trader. The moving average displayed above is the 72-week exponential moving average. That's not a commonly watched average, but anyone who reads my articles or studies my charts will soon learn that it's a moving average that I prefer to watch. Scanning that chart seen above reveals my obvious reasons for watching this average. It's surprising how often it provides support or resistance on weekly closes. In fact, I watch the 72-ema on the daily chart, too.

Annotated Daily Chart of the SPX:

If different traders look at different moving averages, and certain moving averages lose their relevance from time to time, how does a trader confirm that a moving average is an appropriate support or resistance line? The action pointed out in the charts above serves as fair confirmation, all by itself. When you see prices repeatedly bouncing from a moving average in an uptrend or bouncing back from one in a downtrend, that average has been serving as support or resistance. However, adding a bottom indicator, such as MACD, CCI, stochastics or my own favorite, RSI, can help confirm that that support or resistance. Let's look at the first chart again to see how RSI worked to confirm the weekly 72-ema's importance.

Annotated Weekly Chart of the SPX:

The SPX's rally stumbled this summer, repeatedly piercing the weekly 72-ema, with RSI confirming a possible loss of support. The rally got to its feet again, but bulls were alerted to be careful and to have their profit-protecting plans in place. A trend change has not yet occurred: the SPX did, after all, bounce again from that average. However, bulls have been warned to be watchful as the long-term moving-average support doesn't look as inviolable as it did earlier. Leading into this summer, however, for several years, RSI confirmed the importance of the weekly 72-ema in providing support throughout 2004 and 2005.

The averages on these charts are 72-ema's or 72-period exponential moving averages. Most traders probably understand that moving averages come in two varieties, but for those who might be new to technical analysis the two types are simple moving averages and exponential moving averages. Simple moving averages give equal weight to all the periods used in computing the averages. They're the kind of averages you used to calculate in fourth grade. For example, if a 50-day moving average is employed, each day's results in that 50-day period is added to the sum once before that sum is divided by 50. Each day's activity carries an equal weight in calculating the average. When an exponential moving average is employed, more weight is given to the more recent action. So, if there's been a big move, the exponential moving average moves faster. It will often cross above the simple moving average in rallies and below in declines.

Many old-school market pundits suggest using exponential moving averages for longer-term averages, such as those viewed on a weekly chart, because of their tendency to give more weight to the recent action. Perhaps you don't want to give too much weight to an event that occurred 200 weeks ago, for example, but would rather give more weight to the most recent weeks.

Many even suggest the exponential moving average for the 200-day moving average. I keep it on all my daily charts. Tech stocks and tech-related stocks tend to find support or resistance at that average as much as at the simple moving average version.

Recently, however, an experienced trader noted that he relies exclusively on ema's on the intraday charts, but uses sma's on the daily and weekly ones. Upon reflection, I realized that I watch the 100/130-ema's on intraday charts, so I'm watching some intraday action using exponential averages, too. I also watch the 10- and 30-week simple moving averages, so I'm using some simple moving averages on the weekly chart.

Traders also vary the periods used to compute those averages. Some use a 9-day moving average, while others swear by a 10-day one. Some use a 20-period moving average; others, a 21-day one. In addition to the typical 50- and 200-period moving averages, I also often employ that pairing of the 100- and 130-ema's across various time frames. When I'm studying nested Keltner channels, I used a 120-ema rather than a 100-ema.

Confused? You don't have to be. Most charting services allow you to easily employ several moving averages, some set to custom periods. Try several. If you find that prices tend to find either support or resistance at a certain moving average, continue to watch that average for that period of time for that entity. Consider it a treasure hunt. Add your favorite indicator such as MACD, CCI, stochastics or RSI.

When prices start regularly trading across that average rather than finding either support or resistance at that average, especially when your indicator is also violating support or resistance, it's time to rely less heavily on that moving average to provide support or resistance. A period of disorganization is occurring. The trader is signaled protect profits and perhaps, if not yet in any plays, to stand aside until new resistance or support levels are established.

Until that disorganization occurs, however, it's best to assume that an average that has been providing either support or resistance for a long time will continue to do so. It's defining support or resistance for the time being. So, the key to using moving averages to help define support or resistance is to be flexible and look for corroboration from a favorite indicator.

Moving averages provide only one tool for studying support and resistance. The next few articles will discuss others.

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