The Most Important Question a Daytrader Asks

09/13/2010 11:18 am EST


By Adam Grimes, trader, SMB Capital

One of the most important questions in trading is “Will the support/resistance level hold or fail?” (One of the other very important questions is “Is this market trending or in a trading range,” but these are really the same question because trends repeatedly break support/resistance and support/resistance holds in trading ranges.) Many traders do not realize that there are some very characteristic price actions associated with levels holding or breaking, and, more often than not, it is possible to tell in advance what is likely to happen around a level.

The key element of price action in a support level (I will write this blog dealing specifically with support, but everything applies equally well to resistance) is price rejection at the level. Simply put, as the market comes down to the level, buyers immediately step up and push the market away from the level. It feels (and it is not inappropriate to talk about subjective feelings in these discussions) like the market does not want to be at the level and there is a move away from the level very quickly.

On the other hand, if the market is able to go quiet and dull at support, there is a much higher probability of the level failing. The fact that the market is able to trade at or near (whether slightly above or below) support usually presages the level breaking and price trading through.

A few other points to consider: Words like “soon” and “immediately” must be taken in context of the time frame, which is why some traders prefer to think in “bars.” If the level is an important multi-year level, price may well do work around the level for many weeks in a successful test. On the other hand, tests of highs and lows of the previous day in individual stocks usually see price rejection within five to ten minutes if they are going to hold cleanly. Second, anything can happen in the market at any time. Never think that something will happen or something has to happen, because the best we can do as traders or analysts it to define the most probable outcome. Even if we are very good and are working with a very high-probability pattern, we will be right maybe 60% of the time (and often far less), so that still leaves a significant percentage of the time that these patterns do not work as expected. All that matters is you understand the edge and what will happen over a very large sample of trades, and then make sure you are aligning your trades with the probabilities.

Lastly, these patterns are most useful if you own them and make them your own. I have trained traders in the past and one of the exercises I had them do was literally to find several hundred examples of support/resistance both holding and failing on daily charts, and then to examine price action on intraday charts around those levels. You really do have to see many hundreds of patterns before you are comfortable with all the variations of holding and failing (and then failures of failures). I do not believe it is constructive, or even possible, to catalog all of the possible variations, but intuition will slowly grow from repeated exposure. Be aware that there is a tremendous difference between understanding patterns and trading, and this is but one of many important elements of price action.

NEXT: Case Study Using Recent Market Action


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Daily Cocoa Futures

Let’s look at how this played out in the cocoa futures market this past week. (Yes, I have deliberately picked a market that will be somewhat esoteric to many of my readers, but these concepts apply without loss of generality to any market and any time frame.) The bigger picture (not visible on the small chart) is that cocoa has been in a downtrend after dropping below important support, consolidating lower, and extending into another trend leg down. The last downtrend ended on the last day of August (the first blue-bodied candle on the chart below) with an outside bar that defined support and resistance for the next two weeks. We had several successful tests of resistance marked A on the chart below. (Note that this is a different type of test where the level was penetrated but held on the close of the bar. In many ways, this is a more meaningful test than a clean test.) I was expecting that support would break and the market would trade lower, but one day held cleanly to the tick (marked B), and the next dropped support (C). Let’s look at B and C in detail:

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Here we can see the price action on the day marked B on the daily chart, which shows clear price rejection at the level.  I have added a very short-term moving average (a three-period moving average using (H+L+C)/3 as the price point for the average) as a tool to help outline the price action. I would not suggest using a short-term average like this in actual trading, but it is a good tool to help the eye see the overall trend of prices. In fact, it is useful to examine the action of a short-term average like this around many different support/resistance levels as a tool for learning. At any rate, we do see a textbook example of price rejection here as the level holds.

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At C, we see a completely different type of price action.  First of all, we should have been on alert because price “should not” have been back at the level the next day if it was going to hold. A successful test with price rejection like we had the day before should have led to a series of higher lows as buyers held the market above the level. The next day, we are back at the level and now price goes dull and quiet at the level. We can see this in the price bars, but also in the moving average that consolidates near the level, then bleeds down through the level as the level fails.

Keep in mind that a successful test does not mean the market moves away from the level, never to return. Your trading strategy must have some rules for taking partial profits if you are going to make these kinds of trades because a move of a few bars away from the level is a reasonable expectation for a successful test. Buying support and selling resistance are, at best, low-probability trades, but being aware of this key element of price action can give the trader an edge in these very difficult trades.

By Adam Grimes, trader, SMB Capital

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