Think of security prices as the result of a head-to-head battle between a bull (the buyer) and a bear (the seller). The bulls push prices higher and the bears push prices lower. The direction prices actually move reveals who is winning the battle.
Using this analogy, consider the price action of Phillip Morris in Figure 6. During the period shown, note how each time prices fell to the $45.50 level, the bulls (i.e., the buyers) took control and prevented prices from falling further. That means that at the price of $45.50, buyers felt that investing in Phillip Morris was worthwhile (and sellers were not willing to sell for less than $45.50). This type of price action is referred to as support, because buyers are supporting the price of $45.50.
Figure 6
Similar to support, a "resistance" level is the point at which sellers take control of prices and prevent them from rising higher. Consider Figure 7. Note how each time prices neared the level of $51.50, sellers outnumbered buyers and prevented the price from rising.
Figure 7
The price at which a trade takes place is the price at which a bull and bear agree to do business. It represents the consensus of their expectations. The bulls think prices will move higher and the bears think prices will move lower.
Support levels indicate the price where the majority of investors believe that prices will move higher, and resistance levels indicate the price at which a majority of investors feel prices will move lower.
But investor expectations change with time! For a long time investors did not expect the Dow Industrials to rise above 1,000 (as shown by the heavy resistance at 1,000 in Figure 8). Yet only a few years later, investors were willing to trade with the Dow near 2,500.
Figure 8
When investor expectations change, they often do so abruptly. Note how when prices rose above the resistance level of Hasbro Inc. in Figure 9, they did so decisively. Note too, that the breakout above the resistance level was accompanied with a significant increase in volume.
Figure 9
Once investors accepted that Hasbro could trade above $20.00, more investors were willing to buy it at higher levels (causing both prices and volume to increase). Similarly, sellers who would previously have sold when prices approached $20.00 also began to expect prices to move higher and were no longer willing to sell.
The development of support and resistance levels is probably the most noticeable and reoccurring event on price charts. The penetration of support/resistance levels can be triggered by fundamental changes that are above or below investor expectations (e.g., changes in earnings, management, competition, etc) or by self-fulfilling prophecy ( investors buy as they see prices rise). The cause is not as significant as the effect--new expectations lead to new price levels.
Figure 10 shows a breakout caused by fundamental factors. The breakout occurred when Snapple released a higher than expected earnings report. How do we know it was higher than expectations? By the resulting change in prices following the report!
Figure 10
Other support/resistance levels are more emotional. For example, the DJIA had a tough time changing investor expectations when it neared 3,000 (see Figure 11).
Figure 11
There is nothing mysterious about support and resistance--it is classic supply and demand. Remembering "Econ 101" class, supply/demand lines show what the supply and demand will be at a given price.
The "supply" line shows the quantity (i.e., the number of shares) that sellers are willing to supply at a given price. When prices increase, the quantity of sellers also increases as more investors are willing to sell at these higher prices.
The "demand" line shows the number of shares that buyers are willing to buy at a given price. When prices increase, the quantity of buyers decreases as fewer investors are willing to buy at higher prices.
At any given price, a supply/demand chart (see Figure 12) shows how many buyers and sellers there are. For example, the following chart shows that, at the price of 42-1/2, there will be 10 buyers and 25 sellers.
Figure 12
Support occurs at the price where the supply line touches the left side of the chart (e.g., 27-1/2 on the above chart). Prices can't fall below this amount, because no sellers are willing to sell at these prices. Resistance occurs at the price where the demand line touches the left side of the chart (e.g., 47-1/2). Prices can't rise above this amount, because there are no buyers willing to buy at these prices.
In a free market these lines are continually changing. As investor expectations change, so do the prices buyers and sellers feel are acceptable. A breakout above a resistance level is evidence of an upward shift in the demand line as more buyers become willing to buy at higher prices. Similarly, the failure of a support level shows that the supply line has shifted downward./p>
The foundation of most technical analysis tools is rooted in the concept of supply and demand. Charts of security prices give us a superb view of these forces in action.
Following the penetration of a support/resistance level, it is common for traders to question the new price levels. For example, after a breakout above a resistance level, buyers and sellers may both question the validity of the new price and may decide to sell. This creates a phenomena I refer to as "traders' remorse" where prices return to a support/resistance level following a price breakout.
Consider the breakout of Phillip Morris in Figure 13. Note how the breakout was followed by a correction in the price where prices returned to the resistance level.
Figure 13
The price action following this remorseful period is crucial. One of two things can happen. Either the consensus of expectations will be that the new price is not warranted, in which case prices will move back to their previous level; or investors will accept the new price, in which case prices will continue to move in the direction of the penetration.
If, following traders' remorse, the consensus of expectations is that a new higher price is not warranted, a classic "bull trap" (or "false breakout") is created. As shown in the Figure 14, prices penetrated the resistance level at $67.50 (luring in a herd of bulls who expected prices to move higher), and then prices dropped back to below the resistance level leaving the bulls holding overpriced stock.
Figure 14
Similar sentiment creates a bear trap. Prices drop below a support level long enough to get the bears to sell (or sell short) and then bounce back above the support level leaving the bears out of the market (see Figure 15).
Figure 15
The other thing that can happen following traders' remorse is that investors expectations may change causing the new price to be accepted. In this case, prices will continue to move in the direction of the penetration (i.e., up if a resistance level was penetrated or down if a support level was penetrated). [See Figure 16.]
Figure 16
A good way to quantify expectations following a breakout is with the volume associated with the price breakout. If prices break through the support/resistance level with a large increase in volume and the traders' remorse period is on relatively low volume, it implies that the new expectations will rule (a minority of investors are remorseful). Conversely, if the breakout is on moderate volume and the "remorseful" period is on increased volume, it implies that very few investor expectations have changed and a return to the original expectations (i.e., original prices) is warranted.
When a resistance level is successfully penetrated, that level becomes a support level. Similarly, when a support level is successfully penetrated, that level becomes a resistance level.
An example of resistance changing to support is shown in Figure 17. When prices broke above the resistance level of $45.00, the level of $45.00 became the new support level.
This is because a new "generation" of bulls who didn't buy when prices were less than $45 (they didn't have bullish expectations then) are now anxious to buy anytime prices return near the $45 level.
Figure 17
Similarly, when prices drop below a support level, that level often becomes a resistance level that prices have a difficult time penetrating. When prices approach the previous support level, investors seek to limit their losses by selling (see Figure 18).
I kept discussions of price action, investor expectations, and support/ resistance as concise as possible. However, from my experience working with investors, I am thoroughly convinced that most investors could significantly improve their performance if they would pay more attention to the underlying causes effecting security prices: investor expectations and supply/demand.
The following is a very brief review of the support/resistance concepts discussed in this section.
Figure 18
In the preceding section, we saw how support and resistance levels can be penetrated by a change in investor expectations (which results in shifts of the supply/demand lines). This type of a change is often abrupt and "news based."
In this section, we'll review "trends." A trend represents a consistent change in prices (i.e., a change in investor expectations). Trends differ from support/resistance levels in that trends represent change, whereas support/resistance levels represent barriers to change.
As shown in Figure 19, a rising trend is defined by successively higher low-prices. A rising trend can be thought of as a rising support level--the bulls are in control and are pushing prices higher.
Figure 19
Figure 20 shows a falling trend. A falling trend is defined by successively lower high-prices. A falling trend can be thought of as a falling resistance level--the bears are in control and are pushing prices lower.
Figure 20
Just as prices penetrate support and resistance levels when expectations change, prices can penetrate rising and falling trendlines. Figure 21 shows the penetration of Merck's falling trendline as investors no longer expected lower prices.
Note in Figure 21 how volume increased when the trendline was penetrated. This is an important confirmation that the previous trend is no longer intact.
Figure 21
As with support and resistance levels, it is common to have traders' remorse following the penetration of a trendline. This is illustrated in Figure 22.
Figure 22
Again, volume is the key to determining the significance of the penetration of a trend. In the above example, volume increased when the trend was penetrated, and was weak as the bulls tried to move prices back above the trendline.
Moving averages are one of the oldest and most popular technical analysis tools. This chapter describes the basic calculation and interpretation of moving averages. Full details on moving averages are provided in Part Two.
A moving average is the average price of a security at a given time. When calculating a moving average, you specify the time span to calculate the average price (e.g., 25 days).
A "simple" moving average is calculated by adding the security's prices for the most recent "n" time periods and then dividing by "n." For example, adding the closing prices of a security for most recent 25 days and then dividing by 25. The result is the security's average price over the last 25 days. This calculation is done for each period in the chart.
Note that a moving average cannot be calculated until you have "n" time periods of data. For example, you cannot display a 25-day moving average until the 25th day in a chart.
Figure 23 shows a 25-day simple moving average of the closing price of Caterpillar.
Figure 23
Since the moving average in this chart is the average price of the security over the last 25 days, it represents the consensus of investor expectations over the last 25 days. If the security's price is above its moving average, it means that investor's current expectations (i.e., the current price) are higher than their average expectations over the last 25 days, and that investors are becoming increasingly bullish on the security. Conversely, if today's price is below its moving average, it shows that current expectations are below average expectations over the last 25 days.
The classic interpretation of a moving average is to use it to observe changes in prices. Investors typically buy when a security's price rises above its moving average and sell when the price falls below its moving average.
"Buy" arrows were drawn on the chart in Figure 24 when Aflac's price rose above its 200-day moving average; "sell" arrows were drawn when Aflac's price fell below its 200-day moving average. (To simplify the chart, I did not label the brief periods where Aflac crossed its moving average for only a few days.)
Figure 24
Long-term trends are often isolated using a 200-day moving average. You can also use computer software to automatically determine the optimum number of time periods. Ignoring commissions, higher profits are usually found using shorter moving averages.
The merit of this type of moving average system (i.e., buying and selling when prices penetrate their moving average) is that you will always be on the "right" side of the market--prices cannot rise very much without the price rising above its average price. The disadvantage is that you will always buy and sell late. If the trend doesn't last for a significant period of time, typically twice the length of the moving average, you'll lose money. This is illustrated in Figure 25.
Figure 25
Moving averages often demonstrate traders' remorse. As shown in Figure 26, it is very common for a security to penetrate its long-term moving average, and then return to its average before continuing on its way.
Figure 26
You can also use moving averages to smooth erratic data. The charts in Figure 27 show the 13 year history of the number of stocks making new highs (upper chart) and a 10-week moving average of this value (lower chart). Note how the moving average makes it easier to view the true trend of the data.
Figure 27
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