Traders use various techniques to define support and resistance. The most conventional tools [I know of] for defining support and resistance are trendlines, channels, horizontal lines, moving averages and Fibonacci retracements. Each of these categories are then defined further into subcategories. For example, when using moving averages, traders use different time periods and also will compute the moving averages using different methods; some traders prefer simple moving averages while others prefer an exponential moving average. There are also differing opinions on drawing Fibonacci lines.
Ultimately, it will be a winning formula if a trader can correctly pinpoint support and resistance levels, enter trades near support and resistance and manage risk properly. Put another way, at its core, technical analysis is about identifying support and resistance levels. But are you sure that you are correctly identifying support and resistance for a particular security?
The one mistake I have made in the past (and still do from time to time) and that I see other traders make all the time is picking a favorite method for determining support and resistance rather than determining which method market participants are using as support and resistance for a particular stock. On some securities, a 50-day SMA might be a key support level. Another security might use the 50-day EMA or simply follow a trendline instead of hugging a moving average.
For example, take a look at FXE.
You could imagine a trader drawing a trendline or using a moving average other than the 50-day SMA. However, it is pretty clear that support on FXE is defined using the 50-day SMA. FXE also reacts predictably to Fibonacci retracements. Fibonacci retracements also often highlight prior horizontal support and resistance. The 78.6% retracement highlights horizontal resistance from May-July of 2008.
A security like FXE is therefore great for trading because it reacts predictability and we can feel confident about correctly locating support and resistance.
In contrast, take look at AMGN.
AMGN is all over the place. I have no clue where support and resistance is on this stock.
So there are two takeaways. First, when identifying support and resistance for a security, make sure you are using the most precise technique and remain flexible. It requires more time than a canned approach (“I get better results with the EMA” or “I don’t use trendlines”) but should provide better results. Second, stay away from securities where support and resistance is not clear. Why trade a stock that does not trade predictably or that trades sloppy? A sloppy trading stock is more likely to stop you out even if you are right about the direction.
From time to time, I create a “preferred trading list” which is a watchlist of securities that have historically behaved predictably.
Below are 7 stocks that are near or slightly above their all time high and that use the 50-day SMA as support over the last 6 months. This is one of my preferred lists. Depending on market conditions, I may buy any of these off the 50-day SMA. I’m already in AAPL.
These stocks are also market leaders meaning they can also be used as an additional indicator of market health. If we start seeing these stocks breakdown below their 50-day SMA, it will provide confidence that a correction is in order. This is especially true with defensive names such as GIS and KMB. When the market gets soft, money rotates into these names; note that XLP is currently near its all time high and that this rotation is already in process. However, if the correction is substantial, the tide lowers all boats and defensive names will fall too.
AAPL
BLK
ACL
WIT
KMB
ESRX
GIS
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