Even Simple Technical Analysis Works

06/03/2010 12:01 am EST

Focus: STRATEGIES

Corey Rosenbloom

Founder and President, Afraid to Trade

It’s recent days like the chart below that the broader trading public learn the benefit of even simplistic technical analysis and levels to watch.

You don’t have to be a chart wizard to know key levels to watch that are likely turning points in a market.

Let’s take a look at a daily chart of the S&P 500 from last week, for example:


Click to Enlarge

Some people believe that stock prices are random, and that no one can predict the future. If you’ve lost money trading, you’re more likely to adopt that philosophy!

Usually, the truth is in the middle. Stock prices are neither 100% predictable/forecastable every single day, nor are they absolutely random or 100% unpredictable.

Why Did the Market Rally So Sharply That Day?

That’s because—love charts or hate them—everyone can see that 1,050 is a very important prior support level. I called it  “The Edge of the Cliff” in a recent update, and so far, that has been correct.

How can I “predict” that stock prices will rally off 1,050—or fall sharply if under 1,040?

That’s because investors and traders in aggregate—or at least enough of them—watch these levels so as to make them, in essence, self-fulfilling prophecies.

Large funds may decide to buy at a level where they feel comfortable that “everyone” will be buying, and those are usually at blatantly obvious chart levels.

In addition, those who are short selling see the 1,040/1,050 area as a target that they are playing for, and thus they take off—or buy to cover with a profit—their short-sold positions.

New bulls enter because price is testing a known level, while old short sellers cover with a profit as price enters a key support level.

And the market goes up sharply. We call this “positive feedback” (bulls buying; bears buying).

And those who were aware of these dynamics—and have access to intraday trading accounts—can profit very handsomely from this knowledge.

But What if the Market Broke Through 1,040 That Day?

A nimble trader would have expected a bounce to occur today off such an important support level, but in the event that the market ticked down to 1,035, then 1,030, he or she would flip over to plan B, which would include shorting a breakdown of a critical support area.

A trader would anticipate the opposite feedback loop occurring, such that those bulls who bought at the 1,040/1,050 level expecting a bounce would then sell their new positions on a break under 1,040, which would simultaneously draw in new short sellers looking to take advantage of a breakdown in the market.

This is also a positive feedback loop with bulls selling to stop out (or hedge with short positions) and bears short selling to enter new speculative positions. And I suspect that we would have seen another sharp selloff if we would have seen prices under 1,035 today.

In Conclusion

That’s what being a trader is. That’s why charts can be helpful. A chart is not a 100% crystal clear roadmap to the future, but it does help you understand some of the dynamics and expectations between buyers and sellers/bulls and bears.

In watching key levels that everyone is watching, you can forecast reactions when certain levels are hit and triggered.
You won’t know which way the avalanche will fall, but at a critical level (and 1,045 was critical for more reasons than it was just the February low), you can take advantage of the expected positive feedback loop that develops once a key support level holds—or breaks.

The feedback loop can last a day, a week, or longer, but as a trader, it’s up to you to be quick and unbiased in your approach, and willing to take advantage of which way the market and its participants break.

By Corey Rosenbloom, trader and blogger, AfraidToTrade.com

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