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Price Levels and Trends

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Putting simple technical analysis skills to work will significantly improve your awareness of everyday market activity.

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Avoiding this is like avoiding a plague
We can't understand the advances we made
We've tried to resist but it's so hard to say no
We're pretending to see what the future will hold
--OMD

Prices are where supply and demand meet in financial markets. The study of historical price behavior and patterns is known as 'technical analysis.' While there are many flavors of TA, being able to identify basic chart patterns will take you a long way towards gaining insight into past, present, and perhaps even future market behavior.

Effective market participants are aware of the basic skills of technical analysis and can apply them towards making better sense of financial markets.

Levels: Resistance and Support

A while back, Todd noted that he was using a resistance level of 1200 in the S&P 500 Index (SPX) and support below at SPX 1190 and 1180ish as perspective for his trade. How did he come up with those levels?


Chart courtesy of StockCharts.com

The above 'candlestick chart' shows SPX daily price behavior for the six months leading up to Todd's trade (for a tutorial on how to read candlestick charts, click here). The candle to the far right represents price behavior on the day that Todd initiated his trade. SPX closed at about 1196 on the day. Three horizontal lines have been drawn on the chart. Positions of these lines were determined by looking for price levels that permit touching as many tops and bottoms of the individual daily candles as possible. In other words, we're looking for price levels that represent lots of historical buying and selling activity.

Above the 1196 SPX closing price is a line drawn between 1200 and 1205. This line represents a price level where there is a significant probability that further price gains will be slowed or repelled. Why? Historically, there has been a significant amount of buying and selling at this level (that's why we drew the line here). Previous buyers who purchased shares at, say, 1205 at some earlier date may be waiting to 'break even' and are willing to sell as prices approach the 1205 level. Bearish market players might also 'lean' on this level to sell short. Both of these instances add supply to the market. And from ECON 101, we know that prices tend to weaken when supply hits a market. We call these horizontal levels above current prices resistance because they tend to work against further price increases. The bullish side to this story is that each time prices approach resistance, more of that supply is absorbed by the market. This weakens the resistance and makes future price increases more likely.

Two lines below SPX 1196 have been drawn--one at about 1190 and one further down just below 1180. You can see that historically these have been levels where lots of buying and selling has occurred. Since these levels are below current market prices, they tend to retard further price erosion. Buyers who missed their chance the last time prices were at these levels may be anxious to purchase shares this time around. Short sellers might also use these levels as a reference point for covering their short positions. Either way, demand flows into the market which tends to support prices. Indeed, we call these horizontal levels below current prices support because they tend to retard further price decreases. The bearish side to this story is that each time prices approach support, a layer of demand is absorbed. This weakens support and makes future price decreases more likely.

Drawing these horizontal lines on a chart to determine resistance and support is the most basic (and arguably most important) skill related to what is known as technical analysis. Technical analysis is the study of historical market price and related data to gain insight into historical, current, and (perhaps) future market behavior (Edwards & Magee, 1966; Kirkpatrick & Dahlquist, 2007; Murphy, 1999).

Trends

Another simple but valuable technical analysis skill involves identifying trends. A trend reflects a pattern of increasing or decreasing prices.


Chart courtesy of StockCharts.com

Uptrends are series of generally increasing prices. They are defined by a sequence of 'higher lows.' In the above chart of Deere & Co (DE), there is a discernible uptrend, since we can easily draw an upward sloping line that touches the series at multiple points. Uptrend lines offer some support for prices since buyers tend to 'buy the dips' when prices approach the trend line. Similar to our discussion of horizontal support noted above, trend line support weakens the more it is touched. The above uptrend is considered intact until the series moves beneath the blue line drawn above.


Chart courtesy of StockCharts.com

Downtrends are series of generally decreasing prices. They are defined by a sequence of 'lower highs.' In the above chart of Dell (DELL), observe the discernible downtrend from December through March. We can easily draw a downward sloping line that touches a series of prices near the upper end of downward sloping price channel. Downtrend lines offer some resistance to further price increases since sellers tend to unwind positions near the top of the channel. This downtrend is considered intact until the series moves above the blue line drawn above.

Wrap Up

Being able to identify support, resistance, uptrends, and downtrends are important skills for making sense of market behavior. Putting these skills to work will significantly improve your awareness of important price points in everyday market activity.

References

Edwards, R.D. & Magee, J. (1966). Technical analysis of stock trends, 5th ed. Springfield, MA: John Magee.

Kirkpatrick, C.D. & Dahlquist, J.R. (2007). Technical analysis. Upper Saddle River, NJ: Prentice Hall.

Murphy, J. (1999). Technical analysis of the financial markets. Paramus, NJ: New York Institute of Finance.
No positions in stocks mentioned.

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