Support and Resistance Basics

Support and Resistance

trading trendlinesSupport and resistance is a concept in technical analysis that the movement of the price of a financial instrument will stop and reverse at certain predetermined price levels.

Imbalances in supply and demand create support and resistance levels. For example, when an overwhelmingly high number of buyers step into the market, an indication of support is being put into the market. Conversely, a large number of sellers indicate that there is overhead resistance preventing the commodity futures market from moving higher.

Support and resistance levels can be identified by trend lines. The more often a support/resistance level is "tested" (touched and bounced off by price), the more significance given to that specific level.

If the market continuously trades above the trend line the trend line will become a level of support otherwise known as a support trend line.

Support level is a price level where the price tends to find a trading floor, this means the price is more likely to "bounce" off this level rather than break through it.

Resistance level is the opposite of a support level. It is where the price tends to find ceiling on the way up. This means the price is more likely to "bounce" off this level rather than break through it.

Keep in mind that support and resistance levels are not an exact science. Rarely will you see prices rise to the exact identical level, nor will prices also fall to the same precise price point.

With proper monitoring you will begin to develop a sense of where significant price levels develop over time. Being aware of their existence and location can greatly enhance analysis and forecasting abilities.

Support Equals Resistance

A trading range is a period of time when prices move within a relatively tight range. This signals that the forces of supply and demand are evenly balanced. When the price breaks out of the trading range, above or below, it signals that a winner has emerged. A break above is a victory for the bulls (demand) and a break below is a victory for the bears (supply).

Once the price breaks below a support level, the broken support level can turn into resistance. The break of support signals that the forces of supply have overcome the forces of demand.

The other turn of the coin is resistance turning into support. As the price advances above resistance, it signals changes in supply and demand. The breakout above resistance proves that the forces of demand have overwhelmed the forces of supply.

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Head and Shoulders Patterns

Head and shoulders

trading odds and statisticsThe head and shoulders pattern is a reversal pattern that resemble the upper part of a person's body, specifically a shoulder on either side of a head. The line connecting the left and right armpit is referred to as the neckline. Head and shoulders is a reversal pattern that, when formed, signals the security is likely to move against the previous trend. There are two versions of the head-and-shoulders pattern for commodity trading or commodities futures trading. The head-and-shoulders top is a signal that commodity futures at Active Futures price is set to fall, once the pattern is complete, and is usually formed at the peak of an upward trend. The second version, the head-and-shoulders bottom (also known as inverse head and shoulders), signals that a security's price is set to rise and usually forms during a downward trend.

Both of these head and shoulders have a similar construction in that there are four main parts to the head-and-shoulder chart pattern: two shoulders, a head and a neckline. The patterns are confirmed when the neckline is broken, after the formation of the second shoulder.

Head and shoulders top

The head-and-shoulders top signals to chart users that a price is likely to make a downward move, especially after it breaks below the neckline of the pattern. Due to this pattern forming mostly at the peaks of upward trends, it is considered to be a trend-reversal pattern, as the price heads down after the pattern's completion

This pattern has four main steps for it to complete itself and signal the reversal. The first step is the formation of the left shoulder, which is formed when the price reaches a new high and retraces to a new low. The second step is the formation of the head, which occurs when the price reaches a higher high, then retraces back near the low formed in the left shoulder. The third step is the formation of the right shoulder, which is formed with a high that is lower than the high formed in the head but is again followed by a retracement back to the low of the left shoulder. The pattern is complete once the price breaks below the neckline, which is a support line formed at the level of the lows reached at each of the three retracement levels. The point of breakout is when traders following the pattern would enter the market

Head and shoulders bottom

The inverse head-and-shoulders pattern or head and shoulders bottom as it is frequently called is the exact opposite of the head-and-shoulders top, as it signals that the price is set to make an upward move or reverse. Often coming at the end of a downward move, the inverse head and shoulders is considered to be a reversal pattern, as the price typically heads higher after the completion of the pattern.

Just like the top head and shoulder pattern, there are four steps to this pattern, starting with the formation of the left shoulder, which occurs when the price falls to a new low and rallies to a high. The formation of the head, which is the second step, occurs when the price moves to a low that is below the previous low, followed by a return to the previous high. This move back to the previous high creates the neckline for this chart pattern. The third step is the formation of the right shoulder, which sees a sell-off, but to a low that is higher than the previous one, followed by a return to the neckline. The pattern is complete when the price breaks above the neckline. Once again, the point of breakout is the proper time to enter the market when following the head and shoulders patter.

Slope of the neckline

An ideal head and shoulders pattern has a neckline that is perfectly horizontal, however in the real world; the neckline will in fact be slanted either up or down to some degree. A head and shoulders top pattern sometimes tends to exhibit an upwards angle and a bottom head and shoulders pattern will exhibit just the opposite, a downwards angle.

Target levels

Head and Shoulders is an extremely useful tool estimate and measure the possible extent of the subsequent move from the neckline. To find the distance of subsequent move, measure the vertical distance from the peak of the head to the neckline. Then measure this same distance down from the neckline. This gives the objective of how far prices can fall after the completion of the top formation.

Conversely, when measuring a head and shoulders bottom, simply measure the distance from the bottom of the head to the neckline and measure that same distance up from the neckline to determine the possible price target level after the price break above the neckline occurs.

The greater the distance between the neckline and the top or bottom of the head, the more profit potential the trade has. When the distance between the neckline and peak of the head is narrow, it is generally a good sign that the profit potential will be.

If the price reverts back to the neckline before reaching the profit target, the trade is not working out as planned and must be liquidated as soon as the price crosses back above the neckline with a head and shoulders top and crosses back below the neckline with a head and shoulders bottom pattern.

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Trading During Holiday Season

Day Trading before major holiday

trading online stocksA major holiday is any day the financial markets, futures brokerages banks and public schools are closed. The day prior to the major holiday is typically a random trading day with very little happening to cause any significant price fluctuations.

The markets tend to be extremely random with very little follow thru during these periods of the year as most people are focused on the holiday and not the financial markets.
m. Contract rollover

The final situation where I encourage you to avoid trading is rollover day. Stock index futures contracts have a shelf life of 3 months and at the end of each three month cycle the futures contract is rolled over to the other quarter month. This occurs 4 times per year and I highly recommend you avoid day trading each of these 4 days.

The official rollover day is always posted several months ahead of time on the exchange website of the market you are trading. The CME and ICE exchange and brokerages have the entire roll over calendar for each of the electronically traded contracts available far in advance on their websites.

During roll over day’s traders and hedgers are liquidating one month and initiating the next. There’s too much roll over activity for any meaningful trading to occur that day. Most professional day traders avoid trading these 4 days and I highly suggest you do the same. If you can schedule your vacation days around these 4 days that occur each year.

 Last 30 minutes

During the last 30 minutes I urge traders to not initiate any new positions. If you currently are holding a position that’s fine, but the last 30 minutes does not give much time for a trade to develop and unless you are scalping off tick charts where each trade lasts a few minutes or less I discourage you from initiating positions during final 30 minutes of the day session.

Putting it all together

I’m going to introduce you to 13 different trading methods. These methods are all based on a combination of indicators that I shared with you previously in this course. Some of these trading methods may feel comfortable and second nature and others may feel foreign and completely against your belief system.

The key is to find a few different methods that you feel comfortable and stick to those methods. Trading is difficult enough without having to trade something you don’t inherently believe in; it will make your job much harder and emotionally taxing.

These trading methods use 5 minute bar charts. I have used time frames ranging from 3 minute to 15 minute charts and find that the accuracy is consistent across these timeframes. I suggest you start with the 5 minute bar chart and once you feel comfortable you can experiment with other time frames.

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Generating Entry Signals

The entry rules of the strategies

financial metals marketsMany traders use multiple entry methods and have them programmed into their execution and or charting software so that the computer gives them an entry and an exit signal without them having to watch every market tick.

Some day traders prefer to use trading indicators such as charts that cannot be programmed into the charting software or simply prefer to generate signals visually without relying on the computer indicators. This is common for example if a trader simply uses a moving average crossover or gaps where the indication of entry is based on very simple rules that are almost impossible not to see.

Regardless of how you generate entry signals, people have a habit of forgetting their exact rules or simply misinterpreting the rules either due to confusion, fear or dozens of other mental barriers that can arise when you are just starting out.

Therefore make sure you write down clearly all the conditions to entry well before you generate an entry signal so that there is no confusion or misinterpretation of whether the entry signal is in fact accurate or not

The exit rules of the strategies

Writing down your exit rules and sticking to them is twice as hard as sticking to your entry rules, the reason is twofold. With entry you only have one thing to remember, with exits you have to know when to exit if the position goes your way and when to exit when the position goes against you.

The second reason why dealing with exits is more difficult is because when you are entering a trade you really don’t know and you are going to win or lose, you only have one decision to make it’s either you’re going to enter or your not.

However when you are exiting the trade you have a very good idea if it will be a winner or a loser. Many traders subconsciously or consciously begin to change their mind and rationalize different alternatives and possibilities that could either help them reduce or prevent a loss or conversely if the trade is making money, to increase the profit even further. These thoughts can sway the trader from following his trading plan and executing the orders at the appropriate time.

Therefore it’s very important that you write down the specific exit rules in your trading plan and more importantly follow them precisely in cases of both winning exits and losing exits just the same.  I suggest you write your exits in red and highlight them so there’s no way your eyes can ignore the information at your most vulnerable time

The money management approach you are using

While figuring out how many contract to trade may not seem like the most important decision, it can often cause a delay in the execution of an order if the trader is not familiar with exactly how many contracts need to be placed. Therefore, it’s very important to know the position size method you are using and more importantly what the next trade size will be.

Many times traders will try to determine their positions size at the moment the entry signal is triggered giving the trader literally no time to figure out the proper position size. What happens in these situations, is the trader ends up either trying to guess what the accurate position size actually is or more often panic out of fear and miss the trading opportunity. Either scenario will only bring unneeded stress and fear to your mental state during the time you need it least

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Trendlines and Trading

Trend lines

world currenciesTrend Lines are an important tool in technical analysis for both trend identification and confirmation. Trend lines are utilized in chart analysis to determine the slope or degree of the market trend and assist in ascertaining when the trend is changing.

A trend line is a straight line that connects two or more price points and then extends into the future. Put another way, trend line is a charting technique that adds a line to a chart to represent the trend in the market. These lines are used to clearly show the trend and are also used in the identification of trend reversals. The more points used to draw the trend line, the more validity attached to the existence of a trend

Up trend lines are drawn under the rising markets chart lows. To draw an uptrend the line drawn must connect the two lowest price dip in a series. The third dip will confirm the uptrend.

Down trend lines are drawn above the declining market chart peaks. Downward moving trend lines are drawn on top of the highs, connecting the peaks as they get lower. The downtrend line must connect at least two peaks in a series with the third peak being a confirmation of a down trend.

A horizontal trend or a trading range requires two trend lines. One trend line is drawn above the trading range and must connect at least two successive peaks in price to create a trend line. The second trend line is similarly drawn below the trading range and must also connect at least 2 lowest price dips in succession to create a trend line.

When trend lines are drawn above and below the trading price or trading range, it is sometimes referred to as a trading channel.

A trading channel can also occur when the market is an uptrend or a down trend. To draw an up trading channel you begin by drawing a regular trend line connecting each dip in price as it gets higher. After a trend line is established a channel line is drawn by connecting the peaks in price parallel to the trend line.

To create a down channel a trend line is drawn connecting each peak in price and a channel line is drawn connecting each dip in price parallel to the trend line.

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Double Top and Double Bottom

The double top and double bottom

trader twoThese patterns are formed after a sustained price move in one direction and signal that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. These chart patterns often resemble what looks like a “W” for a double bottom or an “M” for a double top after full formation.

b. The double top appears as two consecutive peaks of approximately the same size. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights. The two peaks are separated by a minimum in price, a valley. The price level of this minimum is called the neck line of the formation. The formation is completed and confirmed when the price falls below the neck line, indicating that further price decline is highly likely.

The double top pattern shows that demand is outpacing supply up to the first top, causing prices to rise. The supply-demand balance then reverses; supply outpaces demand, causing prices to fall. After a price valley, buyers again predominate and prices rise. If traders see that prices are not pushing past their level at the first top, sellers may again prevail, lowering prices and causing a double top to form. It is generally regarded as a bearish signal if prices drop below the neck line.

The profit target on a double top is calculated similarly to the head and shoulders pattern, he distance from the peak of the tallest head to the support line is measured and then subtracted from the support line to determine a valid price target.

If the price action trades back up above the support or the neckline before the profit target is reached, the trade is not working properly and must be liquidated quickly

Many first time traders mistakenly believe the buy point for the double top is when the second top has been formed, this is not accurate. The proper entry point for a double top is after the M shape is complete and the market breaks below the neckline.
Double bottom

A double bottom is the exact opposite of a double top, signaling the ending formation in a declining downtrend, it signals a reversal of the downtrend into an uptrend. The double bottom is formed by two price dips separated by price peaks defining the neck line. The formation is completed and confirmed when the price rises above the neck line, indicating that further price rise is imminent or highly likely.

There should be two price troughs of almost the same depth which should be separated by a clear price peak. The highest point of this peak is the reaction high or confirmation point. The signal to buy is given when the neck line or the resistance line is penetrated to the upside.

The profit target is calculated by adding the distance between the neckline and the bottom of the lowest 2 heads and adding that distance above the neckline. This level becomes the profit target for swing trading at market geeks.

If the price action trades back up above the support or the neckline before the profit target is reached, the trade is not working properly and must be liquidated quickly

As with double tops, novice traders often believe the double bottom pattern has been formed once the second low has been made, however, this is inaccurate. The buy point for a double bottom pattern is when prices breakout above the middle peak of the “W” above the neckline or the resistance level.

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