Have you ever looked at a stock chart and wondered how the heck all of that stuff makes any sense at all? I had, and I spent a long time trying to figure it out. I finally did, and now I'm going to let you in on a little secret. There is one (yes, one) fundamental concept you need to understand about charts in order to utilize them effectively in trading and investing, and that is the concept of support and resistance.
If you never learn anything else about reading charts, learn the concept of support and resistance. Of course, if you want to actually make money in the stock market you're going to need to learn a lot more, but understanding this concept will make everything else much easier. Everything comes back to support and resistance.
Do you remember in middle-school economics or social studies when your teacher taught you about supply and demand? What happens when there is a large supply of a product but not much demand for it? That's right, the price falls. Likewise, as supply decreases or as the demand for the same supply increases, the price will rise. This is why diamonds are expensive. Diamonds are rare, but there is a lot of demand for them because they are beautiful, hence they are expensive. The reason I bring this up is that the same is true for stocks and other investment vehicles. When there is a large supply of shares (a lot of people who want to sell it) and not much demand, prices must fall in order to convince buyers to buy. Likewise when there are a lot of people who want to buy and not many people who want to sell, shares of the stock are hard to come by, so sellers get to name their price, driving the price back up. This is where the concept of support and resistance plays a role. Before we get into this too deeply though, let's define support and resistance:
- Support: A price level which the stock has historically had difficulty falling below.
- The reason support exists is that (in theory, at least), as the price of the stock falls, more and more buyers will want to own it (because it's cheap, a good value, see? This isn't hard!) At some point, as the price moves down, buyers will outnumber the sellers in the market, and the price will start to rise again because of the influx of buying activity (lots of demand = high prices!)
- Resistance: A price level which the stock has historically had difficulty rising above.
- The reason resistance exists is the exact opposite of the reason that support exists. At some point as prices rise, buyers simply will not be willing to pay more for the stock, and thus sellers must lower their prices in order to be able to sell the stock (lots of supply = low prices!)
If you're still following me, there's a good chance that at this point you're wondering why this makes any difference at all and why I'm rambling about it. Well check this: when that person finally cracks, whether it's a buyer or a seller, it starts an emotional chain reaction that echoes throughout the market. Think of it this way. If the price of a loaf of bread were rising at a dollar per hour and you needed bread, would you wait to get it? If you would you're either stupid or you're already rich (but still stupid). Of course you wouldn't wait! You'd grab your shoes and be out the door after your loaf of bread so you could get it at the cheapest price. The same thing happens in the stock market when the price rises above a resistance level: all those buyers who were dragging their feet suddenly go "oh crap! I need to get this now no matter what price it is because it's only going to get more expensive!" The result is a huge influx of buyers which drives the price up until all the buyers who wanted shares have bought, and the ones who weren't quick enough have given up and think it's too expensive (keep those guys in mind). That's where you run into the next level of resistance.
As you would expect, the same is true in the opposite direction. The emotional chain reaction goes backwards, with sellers quickly dumping their shares when they see a key level of support fall apart because they want to get as much money as they can for their shares, and they know that prices are only going to fall further. The influx of sellers drives prices down to the next level of support, where there are no more sellers willing to sell, and the buyers who missed the boat last time (remember those guys I told you to keep in mind?) come in to prop the price back up (support!) Finally, if the buyers get control again, the sellers who didn't sell fast enough last time will provide the resistance that buyers need to break through. This cat and mouse game can only go on for so long before the number of people who want to buy or sell has completely dwindled to nothing unless the price changes significantly. When price finally changes, that's when you get a KABOOM!
When you read about support and resistance on other blogs and investing websites, what you'll often find are pictures of charts illustrating support or resistance but no explanation of why it is significant or meaningful. To illustrate how you can use this concept to make money in the market, which is after all the reason we do this, I'm going to show you the chart for a trade my team took today and explain key support and resistance levels (I've drawn them in blue) and how we used them to determine the perfect times to buy and sell, all day long (I recommend opening this chart in a new window so you can follow along):
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Before we get started, each of these "candles" represents five minutes, since this is a five minute chart, and shows you the price range the stock traded in during that period. You can follow the timeline along the bottom and the prices along the right. Each bar in the graph at the bottom shows you the volume or the number of shares that changed hands during that five minute period of time. Candlesticks, volume, and all the other lines/numbers on this chart are something that we'll get into in more detail in another post, but for now, just know that they exist and try to understand the basics of what they represent.
Around 8:30am we got word in our chat room that this company (a medical company called Vermillion) had just issued a press release: something about one of their drugs passing a significant milestone and getting some kind of approval. What the release was about didn't matter, the point was that the market saw it as a good thing and for some reason seemed to think it made the stock worth a lot more. Lots of buyers rushed in to snatch up shares and even before 9am we can see that the chart is significantly higher than the day before. As soon as we opened this chart we knew it was going to be huge. You can see that immediately the price hits a wall around $1.80 and then pulls back. Thus we assume that if it picks up again, $1.80 will be a level of resistance and if it breaks through that level, it means it should run to the next level of resistance. We can also see that after hitting a wall at $1.80, the stock fell back to about $1.49 before turning around. Keep in mind this is all before 9am when the market is not even open yet, so we're not giving this too much notice, other than that we're now very interested in that $1.80 mark.
Some of our guys put in orders to buy this stock at $1.81, $1.82, $1.85, and $1.89. Interestingly, if you look at the volume graph, you can see that in that first 5 minute candle after the market opened at 9:30am over 104,000 shares changed hands (either being bought or sold). If you consider the fact that this particular stock typically has a daily volume of around 80,000 shares, you know something big is going on. This stock blew it's normal daily volume out the window in the first five minutes of trading!
Anyway, right at 9:30 we see the large volume spike and almost immediately afterwards another huge spike and the break above $1.80. All the buy orders triggered at that point, and some of our group became proud owners of this sexy new stock. Generally when this happens, we will all immediately place orders to sell the stock if and only if it drops back below the previous level of support because that would mean there weren't enough buyers to keep the price rising. In this case, many people placed their orders to sell much higher (like around $1.75 or $1.70) to minimize their potential loss. So now we wait. The people who bought hold the stock and see what happens. We are carefully watching that $1.80 mark to see if it drops back below, and if it does, we decide whether we want to sell or let the buyers try to take control again and risk losing money. It's common for prices to "retest" these levels once or twice, so it's not wise to jump ship immediately if the support doesn't hold, but that's why we have the other levels of support: to determine a good time to finally let go.
As you can see on the chart, the price rises quickly on huge volume from 9:35 to 9:45, from $1.80 to $2.05, and then starts to fall. We now know that the breakout was successful, it's hit a level of resistance, and that $1.80 is our new support. Now we don't care about $1.49 anymore, we only care about $1.80. If the price drops below that even by a couple pennies, the trade is over. Most people in our group who bought at $1.80 sold everything they had at $2.00 or so because they realized that the volume was starting to shrink. This is an unheard-of gain for basically a ten minute time frame: 11.11%. (on a $2500 investment that's over $275 in ten minutes...I'd say most people would be happy with that!)
Of course there are always the risk takers. In our group that's basically everyone, and they are all master risk managers who pride themselves on minimizing their losses and maximizing their gains. Those people saw the volume spike up again around 11:00 and decided they'd better start watching to see if the stock breaks through the $2.05 mark (the last known level of resistance...are you seeing how this works yet?!) Sure enough, at 11:06am we see another big volume spike, and in the next five minutes the price breaks through $2.05 for another ridiculous gain. Most people here put their buy orders in around $1.90 and sold around $2.15 10-15 minutes later. Some held longer and rode the price up to $2.25 before selling (another 18.4% gain in 15 minutes, or $460 on a $2500 investment). The team continued to do this all day, with people buying and selling at various price points throughout the day based almost entirely on closely monitoring support, resistance, and volume. Some people made literally thousands on this stock today!
Listen, don't get me wrong: these types of plays are rare. It's far from common to see a stock rise over 125% in one day and trade literally 125x its normal daily volume. However, this is a fantastic example of how support and resistance can be used to find the right time to buy a stock, whether you're looking at a chart showing you 5-minute candles like this one, or a chart showing you weekly candles that dates back 5 or 10 years. If you're a long term investor, you might notice that a stock's price always seems to fall back down once it hits a certain level if you look at a chart showing the entire lifetime of the stock. Take a look at Microsoft, and you can see that around $32 has been a resistance point since 2008. The stock is now nearing that level of resistance. Does that signify the start of a new long-term uptrend? Well, let's be realistic, it's Microsoft...their stock has been flatlining since 2000, but you get the idea. Another awesome example is KERX, which we traded recently. This one broke through three levels of resistance in one day because of a good news story about their company: one at $3.70, one at $4, and one at $5. Anyone who entered at the $3.70 or $4 level would have made between 25% and 35% on this trade ($625-875 on a $2500 investment).
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That's all for now ladies and gents, check back soon for more ramblings!
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