Ed Note: This is the forth of a six-part series that provides an overview on how to trade using price action on all time frames and in all markets.
Although there is no universally accepted definition of price action, I use the broadest one--it is simply any move up or down on any chart for any market.
Traders must understand support and resistance if they are going to trade profitably, and there are many more forms of support and resistance than what are usually discussed. In particular, there are many measured move targets that the computer algorithms chase, but are never mentioned anywhere. You can learn to spot them if you study charts and keep asking yourself, “Why did the market just do that?” Everything has to make sense, so if something happens and you do not understand why, assume that you are missing something. Over time, you will miss less and less and eventually you might conclude that every tick matters and makes sense.
Support and resistance are magnets that draw the market to them. As with any magnetic field, the closer the market gets, the stronger the magnetic pull, and the more likely it is that the market will reach the target. Also, as with a magnet, the market often accelerates when it gets close to the magnet. This momentum often results in either a strong breakout or a climatic reversal. Once the market reaches the target, the magnetism usually greatly decreases. It is as if the market turns off the magnet once it is reached.
If the market reverses or breaks out, it then moves to the next support below or resistance above. In a strong bull trend, resistance usually results in a pause because of profit taking or attempts to pick a top, but the trend then resumes up to the next resistance level. In a bear trend, the market usually falls through all support, although it often pauses at each level because of profit taking or attempts to pick a bottom. All bull trends end at resistance and bear trends end at support, and if traders know how to read the changes in buying and selling pressure, transition usually provides several trades in both directions.
The most widely used support and resistance levels are moving averages, trendlines and prior highs and lows. I pay more attention to trendlines and prior highs and lows, but I do look at a 20-bar exponential moving average on intraday charts and 50-, 100-, 150- and 200-bar simple moving averages on daily and weekly charts. On monthly charts, I am primarily interested in trendlines and prior highs and lows. In a bull trend, if there is a trading range below, the top of the range is support. If there is a trading range or significant low above, it is resistance. In a bear trend, the opposite is true.
Trading with trendlines
There are many ways to draw trendlines but it is helpful to use the same approach on all time frames. It can be as simple as drawing a line across a series of highs or lows. It is helpful to create channels, which means drawing lines above and below. The channel goes up in a bull trend, down in a bear trend and sideways in a trading range.
The lines converge in a triangle and diverge in an expanding triangle. When a triangle slopes up or down, it’s a wedge. However, I use the term loosely, and I call any diagonal pattern a wedge if it has three pushes, even if the channel lines are parallel and not convergent (wedge shaped). It does not matter because the pattern functions the same as a textbook wedge.
Pivot points and Fibonacci numbers provide numbers and few reliable trades compared to other forms of price action. Just think about the E-mini intraday chart. On an average day, the range might be 40 ticks. With all of the significant highs and lows during the day and over the previous few days, there are probably 40 or more Fibonacci retracement and extension levels that you can find.
Also, Fibonacci traders allow the market to miss a target by several ticks and still consider the move a Fibonacci level. This means that there are more Fibonacci targets than ticks in the day’s range! The result is that many profitable short-term traders ignore them based on experience.
What about all the Elliott Wave theory, sea shell spirals and laws of nature? It is nonsense and has no rational basis in trading. Yes, some computers use 62% retracements in their algorithms, but far more computers use other aspects of price action. The market might sometimes turn at a Fibonacci level, but this usually is more the result of coincidence. There are so many Fibonacci levels that some will coincide with much more rational and widely used support and resistance, and when the market reverses at a Fibonacci level, it is much more likely due to something else.
Although a 50% retracement is important to traders and it is a Fibonacci number, it has nothing to do with Fibonacci, but rather common sense. Markets exist so that buyers can buy and sellers can sell and both want a fair price, which is usually in the middle. If you want to buy a house, you will offer well below the asking price, and both you and the seller know that the final price will be approximately in the middle. Markets are constantly searching for the best value where bulls and bears are equally satisfied and dissatisfied, and that price is usually near the middle of the probes up and down.
There are other logical factors as well that have to do with the Trader’s Equation. For example, traders tend to go for profit targets that are one or two times greater than the risk. If the market sells off 100 ticks and bounces, a bear looking for a reward equal to his risk will wait for a 50% bounce and then short. He will risk 50 ticks to above the high and try to exit on a test of the low, 50 ticks lower. Because he believes that the sell-off was strong and the low was likely to get tested, he concludes that the probability of his short is high. One can assume that this means 60% or higher. From the Trader’s Equation, you know that you don’t need a huge reward when the probability is high. In fact, you only need a reward equal to your risk. You can then be confident that you only need a 50-tick profit to have a logical trade.