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|Sunday, August 15, 2004|
Good evening friends,
Trading on Friday was uneventful as the markets closed up ever so slightly. There was the same typical lull in volume that occurs many times on Fridays in the summer as everyone escapes to the Hampton's to start the weekend early. The Dow was up +10 points, NASDAQ up +4 points, and the S&P 500 barely budge at all, up less than +2 points.
The markets are moving along at a snails pace these days. The market is currently over sold and due for a bounce. We are now in the middle of August; this is the time when people are returning from vacations in time for the start of school. Sometime within the next couple of weeks I expect volume to start picking up in the markets. Because the markets have sold off over the summer, some buying should start to come in. The charts of the major indexes look very weak and the charts say down. But this downward action will not last forever, a bottom will someday form, and the upward trend will start. Bottoms are always hard to predict, and we do not want to go against the trend so we will stay short for now. Right now the trend is down but knowing the market is over sold and we are expecting volume to increase in the next couple of weeks, we need to be ready to flip over to the long side of the market at the first sign of heavy volume buying.
In a bull market, support is normally pretty safe because stocks are strong, and when they fall back to support, they will most often bounce and continue the uptrend. However, support in a bear market is much weaker than in a bull market. When we look at charts and see support, we wonder if it is strong enough to hold up the stock price. One factor that needs to be considered when measuring support is over all market conditions. In a bear or flat market support is something we have to look at constantly because it is much weaker than it would be in a bull market.
Support is a concentration of buyers that creates equilibrium between buyers and sellers. Buyers think the stock is a bargain at this price and start buying. This action stops the stock from falling as there is now enough demand for the available shares for sale. Likewise, resistance is a concentration of sellers. This is an area where sellers feel the stock is as high as it will go and starting taking profits.
Support levels will help determine at what price level a stock is most likely to break down, and how much downside risk there will be when we take a position. In a flat or sideways market, trading from support levels is crucial to trade effectively. When breakouts do not work, we have to adjust our trading style. We have done this in the past. We adjusted our style to trade pullbacks to support instead of breakouts, and it worked well for us while the market was going nowhere. It is one of the best ways to trade in flat markets that provides limited risk when tight stops below support are properly placed.
How Strong Is Support?
This is the tricky part. If a stock was trading in a certain price range for three months, then obviously that support would be much stronger than a stock that traded in the same range for only a week. That is easy enough to figure out; the harder part to grasp is long term support. Anything over three years is what I call long term support. It is often said that the longer the support has been in place the stronger it is. The more times the support level is tested the stronger it becomes. It is also true that once this support area fails, the ramifications of such a failure would be much worse on the stock price than that of a support area that was relatively weaker (shorter time frame).
I use three years as long term support because anyone that bought the stock three years ago at the support level is probably long gone by now and this weakens the accuracy of price support. It is an inaccurate measure of support if they are no longer in the stock. That is why I believe support anything over three years is highly over rated on individual stocks. It is important to note that this different with indexes - long term support on major indexes or indexes of sectors are accurate over the long haul because they are filled with long term investors who buy and hold much longer than traders do.
Trend Line Support
Trend line support is a little different as well. Long term trends are much stronger than short term trends. Support is relatively weak on a shorter trend line. Stocks tend to trade along trend lines, and for shorter trends, there is an increased likelihood of failure when a stock moves away from its trend line. Long term trends have much stronger support because the trend has been in place for that much longer. Buyers know that the stock has maintained the trend line for a long time and they know that it is much more likely to hold up. The more times the trend line in tested, the stronger it becomes. Like the support lines, if the longer term trend line fails, this will cause a much greater sell off than a shorter term trend line that fails.
As always, volume is key. Movement of the stock price will not stick unless there is volume behind it. If there is enough volume putting pressure on a level of support, even the longest term support can fail. It is like geology, time and pressure, that is all it takes. With enough pressure, it is only a matter of time before support will fail.
We can try to predict news by reading the chart pattern, but unexpected news or an unexpected reaction to the news can never be predicted. Companies get huge contracts only to watch the stocks fail the breakouts. Companies are granted FDA approval on a new product only to see the stocks pull back after a gap up on the news.
The random event is the killer of every chart. It cannot be predicted, anticipated, or protected against. A bad news release in pre-market can gap a stock down below support in no time at all, rendering you helpless. If a stock gaps down on us, support levels do not matter anymore. All bets are off and it is at that point when you need a little luck on your side. Hopefully, there is a reaction bounce so you can get out of the trade with as little loss as possible.
This is not meant to scare everyone off from the concept of using support levels to identify entry points, or where to place stop losses. But, the reality is that we are still dealing with mere probabilities. We know that risk is inherent in trading, and we accept that. Otherwise, we would have our money sitting in a money market fund making 1% if we are lucky. We can identify support on a chart and we can use it to our advantage. The placement of stop loss orders just under the support level is critical to preserving your capital. If the stock fails, I want out and I want out fast. That way, I have lived to trade another day. Support is our friend, along with the trend but we must always remember that strength and safety in support levels are still only mathematical probabilities. Risk is inherent in the stock market at all times and you must be on the defensive to protect yourself from that risk.
In tonight's chart section, previous charts that we have already shown before have been updated so you can see the progress they have made.
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