From the July 01, 2012 issue of Futures Magazine • Subscribe!

Support and resistance: A wave tendency

While there is no such thing as the perfect trading system, certain points on a price chart reveal high-probability opportunities that can lead to some of the best moves in financial markets. There are areas in the pattern that act as magnets to the price action. Understanding where they are allows traders to exercise greater discipline and achieve greater consistency. 

Many traders like to pick tops and bottoms. Sometimes they’ll be right, but nobody is right all the time. Through extended observation, say a person who picks a top or bottom is going to be correct about five or six out of every 10 tries. That might seem like a mediocre statistic, but it takes a lot of skill to bat even 50% forecasting significant turns — something that happens far less than half the time in the markets.

As most traders know, the first move off a high or low doesn’t go far. It’s always a smaller move and generally retests the high/low or goes sideways for an extended period as it sets up for the larger move. Say the trader who attempts to pick the top or bottom rides the first leg and gets caught in the frustrating sequence of the retest. Unless the trader is really good at scalping or swinging on an hourly/daily time frame, he or she will give back a portion of those gains. But if there’s a re-entry on the reversal, and the target is first support/resistance, enough money must be made to make up for the four-to-five times out of 10 that the trader was wrong. If your winners amount to that small first leg of a new move, then you likely aren’t making the money you need on the winners to be profitable over time. 

The polarity flip

Traders have preached through the ages that once you get a winner, you have to let it run. Professional athletes like to talk about how the coach puts the team in a position to win. By understanding the type of moves that can run, the trader finally puts himself in a position to win.

One of the easiest ways to make that happen is to be aware of the polarity flip. Simply put, an area of resistance will turn into support and an old area of support will turn into resistance. Once this phenomenon materializes in a pattern, it leads generally to outstanding moves that put the trader in a position to stack big profits as he lets the winner run.

Let’s review a simple example on a large time frame. “Bull to bear” (below) shows the top of the 2007 bull market in the Dow and the beginning of the bear market. The price action comes down to a near-term support area, which is close to old support on the way up. It bounces then drops to a new low. A multi-week rally materialized, but all it could do was come back to the ridge of old support. Why does this happen?

It could be that late bulls who bought in near the old top didn’t realize they were buying the top and quickly found themselves underwater. By the time that happened, they realized their mistake and attempted to exit as close to breakeven as possible. Smart bears, who realized the trend might be turning, were eager to short the market. The combination of late bulls and timely bears led to the big move south.

Instead of trying to pick the top and suffering through the early stages of a new move, if the trader realizes the flip in polarity generally leads to what proponents of Elliott Wave analysis call the third wave, he puts himself in a position to win more with less risk. While this is an extreme example that preceded the financial crisis, what generally happens in these circumstances is the best move does materialize at this point. 

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