Bulkowski's Finding Support and Resistance

Written and copyright © 2009-2011 by Thomas N. Bulkowski. All rights reserved.

This article discusses how to find areas of support and resistance.

Support and Resistance: Round Numbers

Sorry for the blurry image on the right, but I wanted to keep the size to a reasonable level. Do not adjust your set, as they say.

Let's talk about support and resistance. Starting with the top half of the bar chart.

Point 1 is supposed to point to 8,000, which would be round number support and resistance. Often, people do not buy or sell at odd numbers, such as 8.93. Rather, they use the round number 9.00.

Traders know better and use the oddball numbers (especially when placing stops).

If many people enter or exit their trades on round numbers, those numbers act as support or resistance areas. Price stalls or even reverse there. They are a self-fulfilling prophesy: Since people believe in them, they tend to work.

Support and Resistance: Valleys

Point 2. Valleys or bottoms are often places of support or resistance. Why?

Imagine that you want to buy a stock. Price bottoms and begins rising at a pace fast enough that you miss the turn. Now, it's too late to buy because you are unwilling to pay such a high price. But, when price drops back to where it bottomed last time, you will buy.

Others do the same thing and that buying causes price to rise, forming a bottom. That is how and why double bottoms form.

Support and Resistance: Peaks

3. For the same reason that bottoms show SAR, so do peaks or tops. I show a cluster of them on the chart, circled. Those that missed selling when they had the chance do so when price returns to the price level of a prior peak. When a bunch of sell orders appear, the upward move stops or reverses there.

Support and Resistance: Trendlines

4. A trendline acts as a SAR line. Why do prices trend? I have no idea. Some speculate that it is a slight imbalance of buy or sell orders. Clearly that is true, but why does price hit a trendline and reverse? Good question. This could also be a self-fulfilling prophecy, where traders expect a reversal at a trendline and their selling or buying makes it so.

Support and Resistance: Horizontal Consolidation Regions

5. A horizontal consolidation region (HCR) is a name I coined for price structures that tend to share bottoms or tops or both. They are areas that have a lot of price overlap from day to day. Sometimes, as in this case, they may slope downward some, but a stock enters the price level of these areas in the future and gets stuck -- not always, mind you, but enough to make trading interesting.

Support and Resistance Lines

6. The bottom half of the chart is of the same Dow only I overlayed the support and resistance lines from Patternz. The SAR button on the Chart form will draw green lines of underlying support and red lines of overhead resistance setup by valleys and peaks, and the program highlights round numbers by a dashed line.

Controls found after clicking the Setup button allow you to increase or decrease the number of lines displayed. I like to see lots of lines because a cluster of them tells you how much support and resistance price has to push through. This chart suggests that the Dow is right underneath a thick layer of overhead resistance setup by prior valleys. Whether or not it is strong enough to repel price, only time will tell. Unless, of course, the earth gets hit my a massive asteroid. That would be exciting.

Support and Resistance: Moving Averages

The chart of Jos. A Banks (JOSB) is a screen shot taken in mid 2009, and it shows a 200-day simple moving average in red.

Points A and B show price dropping to the price level of the moving average and bouncing off it. Even the congestion area at C shows support and resistance when price spins around the line.

If you were to change to an exponential moving average, you would find that price point B would be below the moving average far enough that you might be tempted to call it a miss. I show its approximate location as a blue horizontal line.

Moving averages showing support and resistance are another self-fulfilling prophecy, but it depends on the popularity of the moving average (200-day versus, 173-day, for example. Who uses 173?).

Based on the number of charts I had to use to find a decent example, moving average support or resistance doesn't work well on the daily charts. However, I have used them intraday for day trading, so they are helpful there.

Support and Resistance: Gaps

The chart also shows an exhaustion gap at D. Price at E, which is composed of several bottoms, finds support at the price of the gap.

Look at the breakaway gap at F. Price in the swift down-trend to B blows right through any support formed by the gap at F. However, one could argue that point G does find support at the price of the gap. Of course, price on the rise up from point B does not find overhead resistance setup by the F gap.

My book, Encyclopedia of Candlestick Charts, pictured on the right, takes an in-depth look at support and resistance formed by rising and falling windows (which is what gaps are called in candle-speak).

I discovered that gaps don't too work as support or resistance areas. For example, a rising window will support price just 20% of the time. In other words, expect price to drop right through the gap 80% of the time.

-- Thomas Bulkowski

Written and copyright © 2009-2011 by Thomas N. Bulkowski. All rights reserved. After an instrument has been assembled, extra components will be found on the bench.