While discussing candlestick patterns, we had learnt about the entry and the stoploss points. However, the target price was not discussed. We will discuss the same in this chapter.
The best way to identify the target price is to identify the support and resistance points. The support and resistance (S&R) are specific price points on a chart expected to attract the maximum amount of either buying or selling. The support price is a price at which one can expect more buyers than sellers. Likewise, the resistance price is a price at which one can expect more sellers than buyers.
On a standalone basis, traders can use Support and Resistance to identify trade entry points as well.
As the name suggests, resistance is something which stops the price from rising further. The resistance level is a price point on the chart where traders expect maximum supply (in terms of selling) for the stock/index. The resistance level is always above the current market price.
The likelihood of the price rising to the resistance level, consolidating, absorbing all the supply, and declining is high. The resistance is one of the critical technical analysis tools which market participants look at in a rising market. The resistance often acts as a trigger to sell.
Here is the chart of Ambuja Cements Limited. The horizontal line coinciding at Rs.215 on the chart, marks the resistance level for Ambuja Cements.
I have deliberately compressed the chart to include more data points, the reasons for which I will shortly explain. But before that there are two things that you need to pay attention to while looking at the above chart:
- The resistance level, indicated by a horizontal line, is higher than the current market price.
- While the resistance level is at 215, the current candle is at 206.75. The current candle and its corresponding price level are encircled for your reference
For a moment let us imagine Ambuja cement at Rs.206 forming a bullish marubuzo with a low of 202. We know this is a signal to initiate a long trade, and we also know that the stoploss for this trade is at 202. With the new-found knowledge on resistance, we now know that we can set 215 as a possible target for this trade!
Why 215 you may wonder? The reasons are simple:-
- The resistance of 215 implies there is a likelihood of excess supply.
- Excess supply builds selling pressure.
- Selling pressure tends to drag the prices lower.
Hence for reasons stated above, when a trader is long, he can look at resistance points to set targets and to set exit points for the trade.
Also, with the identification of the resistance, the long trade can now be completely designed as follows:
Entry – 206, Stoploss – 202, and Target – 215.
The next obvious question is, how do we identify the resistance level? Identifying price points as either a support or resistance is extremely simple. The identification process is the same for both support and resistance. If the current market price is below the identified point, it is called a resistance point; else it is called a support point.
Since the process is the same, let us proceed to understand ‘support’, and we will follow it up with the procedure to identify Support and Resistance .
Having learnt about resistance, understanding the support level should be quite simple and intuitive. As the name suggests, support is something that prevents the price from falling further. The support level is a price point on the chart where the trader expects maximum demand (in terms of buying) coming into the stock/index. Whenever the price falls to the support line, it is likely to bounce back. The support level is always below the current market price.
There is a maximum likelihood that the price could fall until the support, consolidate, absorb all the demand, and then start moving upwards. The support is one of the critical technical level market participants look for in a falling market. The support often acts as a trigger to buy.
Here is the chart of Cipla Limited. The horizontal line coinciding at 435 on the chart marks the support level for Cipla
Few things that you need to notice on the chart above:
- The support level, indicated by the horizontal line is below the current market price.
- While the support level is at 435, the current candle is at 442.5. The current candle and its corresponding price level are encircled for your reference
Like we did while understanding resistance, let us imagine a bearish pattern formation – perhaps a shooting star at 442 with a high of 446. Clearly, with a shooting star, the call is too short Cipla at 442, with 446 as the stoploss. Since we know 435 the immediate support, we can set the target at 435.
So what makes Rs.435 target worthy? The following reasons back the decision:
- Support at 435 implies there is a maximum likely hood of excess demand to emerge.
- Excess demand builds buying pressure.
- Buying pressure tends to drag the price higher.
Hence for the reasons stated above, when a trader is short, he can look at support points to set targets and to set exit points for the trade.
Also, with the identification of the support, the short trade is now completely designed.
Entry – 442, stoploss – 446, and target – 435
Major and Minor Support and Resistance Levels
Minor support and resistance levels don’t hold up. For example, if the price is trending lower, it will make a low, then bounce, and then start to drop again. That low can be marked as a minor support area since the price did stall out and bounce off that level. But since the trend is down, the price is likely to eventually fall through that minor support level without much problem.
Areas of minor support or resistance provide analytical insight and potential trading opportunities. In the example above, if the price does drop below the minor support level, then we know the downtrend is still intact. But if the price stalls and bounces at or near the former low, then a range could be developing. If the price stalls and bounces above the prior low, then we have a higher low and that is an indication of a possible trend change.
Major support and resistance areas are price levels that have recently caused a trend reversal. If the price was trending higher and then reversed into a downtrend, the price where the reversal took place is a strong resistance level. Where a downtrend ends and an uptrend begins is a strong support level.
When the price comes back to a major support and resistance area, it will often struggle to break through it and move back in the other direction. For example, if the price falls to a strong support level, it will often bounce upward off it. The price may eventually break through it, but typically the price retreats from the level a number of times before doing so.
Trading Based on Support and Resistance
The basic trading method for using support and resistance is to buy near support in uptrends or the parts of ranges or chart patterns where prices are moving up and to sell/sell short near resistance in downtrends or the parts of ranges and chart patterns where prices are moving down.
It helps to isolate a longer-term trend, even when trading a range or chart pattern. The trend provides guidance on the direction to trade in. For example, if the trend is down but then a range develops, preference should be given to short-selling at range resistance instead of buying at range support. The downtrend lets us know that going short has a better probability of producing a profit than buying. If the trend is up and then a triangle pattern develops, favor buying near support of the triangle pattern.3
Buying near support or selling near resistance can pay off, but there is no assurance that the support or resistance will hold. Therefore, consider waiting for some confirmation that the market is still respecting that area.
If buying near support, wait for a consolidation in the support area and then buy when the price breaks above the high of that small consolidation area. When the price makes a move like that, it lets us know the price is still respecting the support area and also that the price is starting to move higher off of support. The same concept applies to selling at resistance. Wait for a consolidation near the resistance area, then enter a short trade when the price drops below the low of the small consolidation.
When buying, place a stop loss several cents (or ticks or pips) below support, and when shorting, place a stop loss several cents, ticks, or pips above resistance.
If you’re waiting for a consolidation, place a stop loss a couple cents, ticks, or pips below the consolidation when buying. When selling, the stop loss goes a couple cents, ticks, or pips above the consolidation.
When entering a trade, have a target price in mind for a profitable exit. If buying near support, consider exiting just before the price reaches a strong resistance level. If shorting at resistance, exit just before the price reaches strong support. You can also exit at minor support and resistance levels. For example, if you’re buying at support in a rising trend channel, consider selling at the top of the channel.
In some cases, you may be able to extract more profit if you let a breakout occur, instead of selling at minor support and resistance. For example, if you’re buying near triangle support within a larger uptrend, you may wish to hold the trade until it breaks through triangle resistance and continues with the uptrend.
There is also a concept that old support can become new resistance or vice versa. This isn’t always the case but does tend to work well in very specific conditions, such as a second chance breakout.