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Section 3:

Support and Resistance II

 

 

Channels

Diagonal support and resistance levels often form on the same chart in the same timeframe. The diagonal support and resistance level appear as exact opposites, or mirror images. The formations are known as channels. The competing buyers and sellers who are behind the support and resistance, respectively, are disagreeing within the context of a directional move either up or down.

There are bullish channels and bearish channels. In bullish channels, buyers are willing to let the stock fall only so far before stepping in and buying at higher and higher prices. Meanwhile, sellers are willing to let the stock run higher by only so much before stepping in and selling at what they perceive to be overvalued prices. The overall move is higher, but it’s in a stair-step fashion.

By contrast, in bearish channels, sellers are willing to let the stock rise only so far before stepping in and selling at lower and lower prices. Meanwhile, buyers are willing to let the stock fall by only so much before stepping in and buying at what they perceive to be an attractive price. The overall move is lower, but it’s in a stair-step fashion.

Bullish Channels

Support and resistance are both defined within the context of a bullish channel. Both support and resistance are upward sloping. The lows for each period, or over the course of multiple periods, tend to move higher. The highs for each period, or over the course of multiple periods, also tend to move higher.

A stock might be moving higher, but along the way it pauses and pulls back to catch its breath. Each time it pulls back, the buyers step in at increasingly higher prices. They start buying, equalizing or overcoming the sellers. The buying causes the price to stop going lower and start moving even higher. Sellers, meanwhile, step in at increasingly higher prices. They start selling, equalizing or overcoming the buyers. The selling causes the price to stop going higher and start moving lower, towards the diagonal support, where the cycle starts all over.

Figure 3.9

Shares of Consol Energy (CNX) traded higher within a bullish channel as shown in Figure 3.9 . The overall path was upward, but the stock took a stair-step approach.

Notice how the buyers stepped in near the lower-end of the channel, at diagonal support, at increasingly higher prices. But the sellers would allow the stock to go only so high, before stepping in and selling at the upper-end of the channel, at diagonal resistance.

Bullish channels don’t go on forever. But bullish channels can end in one of two ways. The stock can break higher or lower.

Figure 3.10

Shares of Archer Daniels Midland (ADM) were steadily rolling higher for several months, using the bullish channel as support and resistance as shown in Figure 3.10 . But notice what happened the last time the stock reached the upper-end of the bullish channel at $39. The stock hesitated for several days right at $39, at the upper-end of the channel, before exploding higher.

The stock shot higher for six consecutive days after breaking above $39 as buyers piled in. The bullish trend, which was defined by the bullish channel, became even more bullish as the stock broke above the upper-end of the channel.

Bullish channels also end with a breakdown below the lower-end of the channel, at diagonal support. The breakdown below diagonal support usually signals an end to a bullish trend and the beginning of a new bearish trend. Like other breakdowns, the break from a bullish channel is actionable.

Figure 3.11

Shares of Lehman Brothers (LEH) were rolling higher along a modestly upward sloping bullish channel for several months as shown in Figure 3.11 . But the stock broke down below the lower-end of the bullish channel, at diagonal support, near the $72.50 level. The breakdown from the bullish channel led to a dramatic drop in the stock all the way down to $50 per share.

Bearish Channels

Support and resistance are both defined within the context of a bearish channel. Both support and resistance are downward sloping. The lows for each period, or over the course of multiple periods, tend to move lower. The highs for each period, or over the course of multiple periods, also tend to move lower.

A stock might be moving lower, but along the way it pauses and rebounds. Each time it rebounds, the sellers step in at lower prices. They start selling, equalizing or overcoming the buyers. The selling causes the price to stop going higher and start moving even lower. Buyers, meanwhile, step in at lower prices. They start buying, equalizing or overcoming the sellers. The buying causes the price to stop going lower and start moving higher, towards the diagonal resistance, where the cycle starts all over.

Figure 3.12

Shares of Omnicare (OCR) moved steadily lower over the course of a year, finding resistance at the diagonal resistance line and support at the diagonal support line as shown in Figure 3.12 . The diagonal resistance and support lines combined to form a bearish channel.

The stock stopped going higher, within the context of the bearish trend, each time it traded near the diagonal resistance. The stock stopped going lower, within the context of the bearish trend, each time it traded near the diagonal support.

Just like bullish channels, bearish channels don’t go on forever. Bearish channels can break either higher or lower.

A breakdown from a bearish channel usually leads to an increase in the rate of decline in the stock. Put another way, a breakdown from a bearish channel usually leads to an even more bearish trend.

Figure 3.13

Shares of Bear Stearns (BSC) were steadily rolling lower within a tight bearish channel shown in Figure 3.13 . Notice how well-defined the diagonal support and resistance levels were within the context of the bearish channel.

Late in the bearish channel, BSC broke down below the lower-end of the channel, at diagonal support. The breakdown occurred near the $135 level. This breakdown accelerated the stock’s decline as the sellers grew more aggressive and the buyers all but stepped aside.

Bearish channels can also be broken to the upside, when a stock breaks above the diagonal resistance line. A breakout from a bearish channel typically results in a new bullish trend. The breakouts are actionable, often offering entry points into new bullish trends or exit points from existing bearish trends.

Figure 3.14

Shares of Anadarko Petroleum (APC) were trading in a short-term bearish channel, with well-defined diagonal support and resistance as shown in Figure 3.14 . Notice how the intraday highs and lows matched the diagonal support and resistance levels.

But the stock broke free from its pattern of lower highs and lows. Once the stock broke out, near the $49 level, it went on to steadily trend higher. In fact, the stock saw only a handful of down days after it broke from the bearish channel.

Support and Resistance Summary

Whether identifying horizontal support, diagonal support, or a bullish channel, the concept is the same: The stock stops going down near a particular price level. The same holds true for the various forms of resistance. The only difference is that the stock stops moving higher.

The various forms of support and resistance can be used for identifying entry points, determining exit points for profit, and pinpointing exit points from losing trades. Support and resistance levels might even be used as references for stop losses.

No matter how they are used, the concepts of support and resistance are incredibly important to understand. Identifying these levels will become second nature with increasing levels of experience and the observation of more and more charts.

Support and resistance levels can be further organized into formations. These formations are refined even further into different categories of recurring price patterns. Price patterns help to make sense of the price action in stocks. These patterns reveal a clear picture of what the buyers and sellers have been doing. Most importantly, price patterns forecast what buyers and sellers are likely to do in the future.

The building blocks of price patterns are support and resistance levels. These building blocks include horizontal support and resistance, diagonal support and resistance, and bullish and bearish channels. The combination of various types of support and resistance forms the price patterns.