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Layers of Resistance, Layers of Support

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Last week I wrote on how 'resistance' or potential selling pressure might still be 'measured' technically when an index or stock is at either a new all-time high or a new high for a move. One way to measure potential resistance in such instances is by the use of price channels. When there is an uptrend, there is typically a dominant up trendline. A line parallel to such an up trendline touching the highest high that occurred over the duration of such an up trendline forms the upper end of the uptrend channel and may act as either interim, or a pivotal, resistance.

For anyone wanting to go back to my Trader's Corner article of last week (7/18), this column can be viewed by clicking here.

The classic way to measure 'resistance' is to go back to a prior all-time or a prior dominant upswing peak. An index or stock that tops out at a prior high makes a technical double top formation. The record of double tops (and double bottoms) is very good in signaling trend reversals.

A recent and obvious example of a double top was seen in the Russell 2000 Index (RUT), and a less obvious example will follow, that of the S&P 500 (SPX):

A double top is viewed as being 'confirmed' when the dominant downswing low PRIOR to the second top is pierced as is the case above with RUT as it fell decisively below 820, at the prior two lows which formed a minor double bottom. The longer the time duration that passes BETWEEN the formation of the double bottom or double top the more credence is given to the double top or bottom as a reversal point. We'll see this in spades in the S&P 500 (SPX) weekly chart, which is my next chart. This chart also has trend channel lines that form a another version of the weekly chart uptrend channel that I showed for SPX last week:

The S&P 500 (SPX) is considered to be the most important index as a benchmark for fund performance. SPX was widely heralded as being at a new all-time high based on it going to a new all-time high CLOSE. The analysis of the Close as being the key benchmark to gauge the progress of the market began with Charles Dow, who in fact only considered the weekly Close to be important. Not everyone since then has thought that the close only or even the key benchmark high or low, especially WD Gann. I myself recently wasn't paying the closest attention to the prior all-time weekly HIGH (highest daily high of any prior week) in SPX, at 1552.8. WRONG to lose track of that prior all-time High, as we can see in my next chart.

We see an exact double top in SPX in terms of the prior all-time weekly SPX peak at 1552.8 made back in 2000. This level now forms a 'potential' double top relative to the recent high; such a double top would be 'confirmed' by a close below the 1364 prior downswing low (made before the most recent top). However, as we are focused on trading, not making long-term investment decisions, a double top formation is an EXCELLENT signal to buy puts as soon as the double top is apparent, with a exiting stop just above the double top (1553). At that point the risk to reward potential in such a trade is favorable, even if only a moderate correction follows; especially so, in an overbought market as we'll see with the Dow RSI Indicator next.

The other (potential 'double') resistance is seen IF we assume an uptrend channel that connects the MOST number of highs (an 'internal' trendline) rather than the single highest high, as seen below:

The other technical factor to look for when one of the major indexes appears to be hitting potential resistance or is coming close to resistance suggested by an upper trend channel line, is to note if new highs are also occurring in the Relative Strength Index (RSI) indicator on a weekly chart basis. If there is a pattern of higher highs (seen by a rising trendline) when, during the same period, there's a pattern of declining peaks in the RSI, the resulting divergence is a bearish technical indication. Such a divergence suggests being watchful for PRICE action that signals a top or potential trend reversal.

I also revisited the way that I drew my upper trendline on the weekly Dow 30 (INDU) chart below: an 'external' trendline, touching the highest high for the period shown here, intersected around 14,100. When I also drew the upper parallel line through the greatest number of weekly highs recorded in early-2004, resistance implied by this ('internal' upper) trendline intersected right at 14,000 in INDU.

The even-100 or even 1,000 levels in the indexes often assume greater significance than other levels, in terms of marking major support or resistance points. Thinking that INDU might make it up to 14,100, rather than the strong possibility that it might top at the even-14,000 level was just one possibility. Better if I look at the charts from other, or ALL, angles.

I was talking about situations when prices are trending higher and the RSI (Relative Strength Index) is NOT 'confirming' the same action by trending lower. We can say that prices are going up on LESS 'relative strength' as is highlighted in the instances above where the slopes of the (light blue/cyan) trendlines are sloping UP and the RSI peaks are trending DOWN. This type divergence is however, NOT going to signal you as to precisely when a trend reversal might occur. It is rather a broad backdrop to be ALERT for a trend reversal. The way to focus in on that possibility is with the intermediate to short-term daily and hourly charts:

A picture perfect example of a not only a double top, but a classic Price/RSI divergence, was seen recently on the HOURLY Dow chart below. It couldn't be predicted that the resulting pullback would turn out to be as deep as it was but, on the other hand, major Price/RSI divergences on a weekly chart basis often do see BIG corrections follow.

The important thing from a trading standpoint is that as soon as the double top was apparent on the hourly chart, DJX puts could have bought with an exiting stop very CLOSE to the entry point so that trade 'risk' was small. Assuming that the downside was triple that of that risk was almost a conservative assumption. If a subsequent drop was steep, great for the trade and time to look for areas of support as a profit taking point. I at least tend to work that way, with pre-determined exit points, as I don't tend toward being more of a 'trend follower', at least in options. A 'natural' area of INDU support is at or approaching the prior lows in the 13,300 to 13,400 area.

LAYERS OF SUPPORT:

Assuming we get a correction like we're seeing this week, what are the layers of potential support on the downside, on the decline, to look for on a technical basis? Tracking LEVELS of support is important for two reasons: 1.) Where might support develop? and 2.) What is the next downside objective(s) or target support(s) below the technical support just pierced?

1. A PRIOR HIGH
A prior high that was pierced on a rally, especially if that was a line of 2-3 or more prior highs in the same area, should 'become' support on subsequent pullbacks IF the last breakout was valid; i.e., a new up leg or continuation of the dominant trend.

2. AT THE 21-DAY MOVING AVERAGE
This is true of the major INDEXES on a trading basis, not necessarily for stocks. The S&P and Dow in particular tend to hold above the 21-day average in an uptrend or find support on pullbacks in a still valid uptrend. If the 21-day average is pierced, especially if prices knife through this average, look for further weakness or a move to the next lower potential support.

3. AT A PRIOR DOWNSWING LOW(S)
This is especially the case if there were 2-3 or more prior lows in the same area; i.e., there's a retreat to the low end of a prior trading range. This is pretty basic stuff in trading. Everyone looks to see what happens at such prior lows. What the smarter and more successful traders do often however, is to NOT WAIT to see if buyers will win out and prices rebound from, such a prior low or lows. But again this is also a function of the style of trading that you adopt; e.g., more short-term oriented, trading for more intermediate-term prices swings, etc.

In the case of the S&P 100 (OEX), the bulls should have been concerned about the trend once the prior 707 high didn't hold up as new support on the pullback. Normally, traders shorting OEX at the high end of the 707-685 range and who exited shorts by buying (or those buying more on the breakout), would assume that the 707 area was a place to buy again for a next move higher, such as to 730. When that didn't happen and when that same level was AGAIN resistance the next day, we could guess that the Index might again head back to the low end of the prior range. The 685 area today looked like a good place to exit puts short-term. Especially so, when bearish sentiment built up so quickly per my 'CPRATIO' indicator!

4. (SUPPORT AT) THE LOW END OF AN UPTREND CHANNEL

If the upper end of an uptrend channel may prove to be resistance, the reverse is also true: the low end of an uptrend channel will often be where support or buying interest surfaces. If this doesn't happen, look for the next lower support point.

5. AT 3 PERCENT BELOW THE 21-DAY AVG IN THE S&P, DOW AND THE NASDAQ

The S&P and Dow more often than not, tends to trade between 3 to 3.5 percent above, and 3-3.5% below, its 21-day moving average. This same moving average envelope range can widen out a bit more in the Nasdaq; e.g., 3-3.5% to 4% above and below the average.

The upper end of the Nasdaq Composite's (COMP) price range proved to be resistance on the last run up. Support was NOT seen at the 21-day moving average, NOR at the low end of the uptrend channel; i.e., at COMP's up trendline. However, support or buying interest surfaced as the Index neared support implied by it prior low. That this was a good bet for support was also suggested by the lower envelope line, which was equal to 3 percent (below the 21-day centered moving average), the same as the 3 percent envelope line near COMP's recent highs.

The low end of the Nasdaq 100's (NDX) uptrend channel proved to exactly mark the turning point of today's decline as seen with the daily NDX chart and my channel markings below. Note that the upper channel line was pierced on the recent rally, but only for a day. The fact that the Index retreated to below the upper channel line the following day was a telling indication that the trend might start to weaken.


GOOD TRADING SUCCESS!

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Please send any technical and Index-related questions for my answer or feedback to Click here to email Leigh Stevens support@optioninvestor.com with my name ('Leigh Stevens') in the Subject line.
 

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