Sept. 16, 2011- A Little Common Cents Corner #12 – Mechanics of Supports and Resistances + Dead Cat Bounces

All analysts occasionally make statements that appear to be fact, but in many cases, they are statements based on subjective observations and should never be blindly relied upon without a thorough investigation. – Charles KirkPatrick and Julie Dahlquist, “Technical Analysis: The Complete Resource for Financial Markets”

All market participants make mistakes, but the regimented professionals correct theirs quickly.  – Patrick and Dahlquist

“Have you ever bought a stock, watched it decline in price, and yearned to sell out for what you paid for it?  Have you ever sold a stock, watched it go up after you had sold it, and wished you had the opportunity to buy it again? Well, you are not alone.  These are common human reactions and they show up on the stock charts by creating support and resistance.” – Jiler (1962)

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The Mechanics of Supports and Resistances

(For example purposes, I’d be using LC (Lepanto Consolidated Mining) and MA (Manila Mining) only because it is most actively traded and most Filipino readers can probably relate to it.)

We can assume there are potential buyers for LC at price 1.20-1.25, MA at .057-.060 because

1.) Those who sold higher prices (1.60, 0.073 above) /shorted will be covering because they have seen that the price halted its earlier decline at price 1.20,.060, and do not want to take the risk that it will rally again higher, or wiping out their profits.

2.) Those who had been watching the stock but didn’t buy it at 1.20-1.25,.060 earlier will be satisfied that the decline to 1.20/.06 is now back to where they earlier had wanted to purchase it but “missed it” (as it closed at 1.31,.064).

3.) Those who sold the stock during the high volume at 1.20-1.25, .057-.060 when it declined from 1.50s and .075s saw the price immediately rise thereafter (1.30s and 0.064), and wish to reenter a position at the price they sold it earlier.

The reasons are purely psychological, but they are strong reasons by themselves. Note that none of these players is using a fundamental or other informational reason for buying the stock at 1.20s or 0.06 .  The presumption has now become a support zone and that prices will stop declining at that level in the future.  The more frequently prices halt at a zone, the stronger and more important that zone will likely be in the future.  If the presumed zone of support fails, we need to find a new support again.  Hence, it’s easy for traders to just buy and cut losses when proven wrong.

Support and resistance zones therefore are price levels where supply and demand reach equilibrium for unusual but persistent psychological reasons.

Securities occasionally “rest” during a trend and move sideways as the earlier rise or fall is “digested” by all the different players.  The psychology of what causes these spurts, stops and retracements is an interesting study by itself, but again it is irrelevant for our present discussion.  What we want to know above all is, what is the larger trend, and are there signs of it ending or changing direction?

Remember that a trading range is somewhat like a battleground, where the buyers and sellers are warring for dominance.  Before the war is over, it is almost impossible to determine who will win (THUS, pick your spots carefully.  You only buy at one price, and not chase).  It is usually wiser, and more profitable to wait rather than to guess.  Once , however, prices break out of the trading range (this will take months imho), the investor has information about who has won the war.

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But if you must trade deadcat bounces, let these notes remind you:

The “bounce” comes from bargain hunters and bottom fishing traders who are second guessing when the actual bottom will take place.  It gathers momentum from short covering and momentum signals.

1.) Any kind of acceleration is a sign of pure emotionalism and thus a potential sign of an impending reversal.  (If we get accelerations from presumed supports VERY FREQUENTLY, then we have on our hands a support and resistance play.  Else, forget it.)

2.) Even standard fundamental analysis should use some kind of stop.  It is ridiculous to thin that when entering a trade or investment that it will always be successful and that risk of loss should be disregarded. (I’m talking specifically to people who choose to be “ipit” investors.  Even this needs a stoploss level.)

3.) Risk control is sometimes more important than entry technique.  Technical analysis takes knowledge, patience, and close watching of price action, but profits can be made.

4.) Perfection is not in the lexicon of technical analysis.  It is favorable odds, or an “edge”, for which we are looking.  For instance, the only reason why I bottom fished LC at 1.25 is because when proven wrong, the stoploss is easily cut an easily definable cutloss point of a break of 1.20-1.18 levels.  Plus, there’s a cluster of evidence to support the “educated guess that 1.20 will likely hold”, i.e. moving averages, and the large volume of several bids in those areas.

5.) Every trading vehicle has its own “personality”.  Success is often a function of understanding the peculiarities of the trading vehicle most commonly traded.

What I mean by this is that if LC moves in a 10-15 cents range, if you choose to profit from this “average true range”, play the rules correctly and not some idealistic targets of 30 cents, just like last time.  As I said in my previous post, the LambChop (LC) has been given to a swarm of piranhas.  The meat of the move has been taken.  If you want to gnaw at the bones, “tira tira na lang yan”.  If you choose to be a piranha, eat what the market gives you.

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Useful Notes for Traders/Investors Who Choose Not To Trade and Tips on How To Spend the Day Not Trading:

“I’ve learned as a trader, you have to sit through things you don’t love. Suck it up. There’s value in everything, often not immediately obvious. Don’t skip things because you think they are a waste of time. And if in the end it was a waste of time and you’re upset about that… you’re not gonna succeed in trading.” – Tyler Trading

Found via Tadas Viskanta, please read the entire article here:

(All highlights are emphasized by me alone)

1.) For some reason a lot of non-day traders think they have to spend all their time in front of the screens.  This is the case even when things aren’t going all that well.  The fact is that many traders would be better served spending their time doing additional research instead of focusing on the tick-by-tick moves in the market.

2.) Step away from the screens – Peter Brandt

3.) One thing great traders know is when to push their advantage and when to step away and focus on other things.  Losing traders share the common trait of overtrading.  Best traders know when to pick and choose their spots very carefully.  – Robert Sinn

4.) I’m still super passionate about the market so I need somewhere to test my theories and just screw around so I don’t get stuck in a rut.  Thus, I work on research projects unrelated to core trading. – Dynamic Hedge

5.) There is much more to trading than staring at a screen.  There is of course the burnout factor.  The simple fact is that most traders need to step away from the screens so that they can think, write and research.  Only by dedicating time to new paths can they come up with novel ways to trade.  Nobody’s trading system is perfect.  So spending some time away from the screens can provide the impetus needed to become a more successful trader.

*For all my market related posts, just click the category “A Little Common Cents Corner”  Do share this to anyone, if you believe the analysis is something that can benefit others as well.

– Faceless Trader