Predicting Prices Using Support and Resistance Points
Support and resistance (SAR) are first and foremost the most important points to watch in price chart patterns. Finding first and second support points ( S#1 & S#2) and first and second resistance points ( R#1 & R#2) can help you predict how far prices might climb and how far they might fall before you trade. Let’s find out how support and resistance work and how to use pivot points.
Defining Support and Resistance
Support occurs when increased demand for a particular futures market builds a floor under that market’s price. A support level or zone appears when buyers miss purchasing a futures contract and vow to buy it later should prices decline to the same, or nearly the same, level.
Resistance occurs when selling pressure stops a market’s price rise. A resistance level is similar in that traders buy the futures contract just before it tumbles and they vow to sell if its price reaches their purchase price. A common mantra among novice traders is, "as soon as I get my money back, I'm selling."
SAR comes in many flavors, and we’ll discuss the most important one to us: pivots.
Playing the Pivot
Pivot points sound like they could be critical junctures in the market, and for some active traders looking at intraday charts, they are. In fact, just because these traders look at pivot points and respect them may be exactly the reason they often work. That is, they may be a self-fulfilling prophecy because so many traders know about them and trade or fade the same numbers.
A price bar represents all the prices traded in a specific time frame for a particular market, and a pivot point is a computed number based on a price bar’s high, low and close. From it, support and resistance levels are calculated that act as sort of a bracket for the next price bar’s action.
Using Pivots for Support and Resistance
Pivot levels show support and resistance points that can be used for day trading or swing trading. Day trades are those that last for less than one day, while swing trades last between one and five days.
A special mathematical formula calculates three numbers using the high, low and closing price data with volatility, which shows momentum. These numbers come from a proprietary formula. Below are some examples of these types of calculations I do for my clients, taken from the week of April 3 – 7, 2006 for selected markets.
The basic pivot technique involves trading with support and resistance levels derived from the previous day's or week's (what ever time period you want to use) high, low and closing prices. The idea is to sell when price violates these levels on a break and buy when price pushes through them on the upside.
Because former resistance becomes future support and vice versa, these levels provide key stop-loss levels. For example, if you sold when the market broke through support level one, you would immediately place your stop at or just above the support level one price. If the price continues to drop, you can follow the market with a trailing stop. Although these levels sometimes will provide valid support and resistance levels throughout the time period you use, their significance diminishes as they are repeatedly violated. The first time is the most important.
So, what do you have when you apply pivot-point lines to your chart? Active traders treat them like support and resistance levels, acting as potential boundaries for the next bar’s price range. Or, if prices do break through S#1 or R#1, a stop might catch a move to the next target, the S#2 or R#2 line. The support and resistance lines may turn back prices because that’s as far as market strength or weakness can take them or because so many traders expect that to happen, but these lines aren’t walls. What may be more important is how prices react as they approach or break through these lines. When prices are attacking the R#1 and R#2 resistance lines consistently, the bullish trend is entrenched; when prices back away from the R#1 and R#2 lines, the bullish trend is weakening. Like many things about price charts, pivot-point analysis isn’t perfect. It helps if the pivot-point lines coincide with prior highs or lows, chart patterns, candlestick analysis or other corroborating evidence. However, pivot points can be another effective trading tool for your arsenal.
Futures trading involves substantial risk of loss and may not be suitable for all investors.