In today's ezine, I'll be talking about lines of support and resistance, or S/R. We'll take a look at three different charts and see how these lines might influence your trading as a swing trader, an options trader, or a day trader.
We can draw lines on charts all day long. It doesn't mean the stock has to follow these lines. Unforeseen news events can alter the normal path of a stock at any time. And sometimes these lines only make sense in hindsight. Still, it is interesting to study and it can help us both preserve profits and discover new ways of trading.
Our first chart is AA, Alcoa.
We can draw horizontal lines of S/R, such as the blue line I've drawn on the AA chart above. The normal recommendation for S/R lines is at least three points, connected by a straight line. On the AA chart, there are more than three points. But you might choose different points than the ones I chose.
The chart for AA uses weekly candles. This gives more validity to the trend line. The last candle on the right shows a bullish candle, moving between the $9.00 and $12.00 price points. Moving from left to right on the chart, we can see how price fell to this line several months ago, tried to bounce off of it, and then fell through the line for several months.
AA has been moving up with the rest of the market's March rally. After a period of consolidation (above the mid-line of the Bollinger Band) for the last few weeks, it made a rather bold move above the S/R this past week. This last candle is touching the top of the Bollinger Band with very little resistance.
Giving this candle even more weight is the fact that the overall market was not this strong last week. So, AA performed better than the overall market last week. The result is some solid evidence of strength that AA could be ready to break past this S/R line. With S/R lines, what was once a line of Resistance, can now become a line of Support.
Now, before you rush out to buy and hold a bunch of AA stock, let's look a little more closely. Look at the end of December. There is a bullish candle at the end of December that looks a lot like the last candle on the chart. So, in one sense, we've been here before. The thing is to keep watching it. It might be a good swing trade to the long side. It might be a company to watch if the market has a decidely negative day and you want to day trade the rebound. It may be an option play in which you buy Call options that are several months out. All I would say right now is that it is a stock to watch.
The second stock we'll look at is PHM, Pulte HOmes.
Home building has not participated in the April rally. Most investors expect the housing sector to be one of the last sectors to rebound from this recession. With unemployment at 9.4%, this isn't likely to occur anytime soon. So why am I showing you this chart?
PHM is an example of a rolling chart. The first give-away is the sideways price pattern. Day trading a stock that is moving sideways is nearly impossible. But, looking at these weekly candles a little closer, you might see that the pattern is more of a rolling motion.
I've drawn two different S/R lines here because price seems to keep bouncing from one end to the other. Price never seems to move much higher or lower than either of these two lines. And, if you look even closer, you'll see that price tends to reach each extreme within a 4 candle or 4 week period. In other words, once it hits the bottom line, then it tends to hit the other line within 4 weeks.
Eventually, PHM will break out of this pattern. It will probably break to the upside once the housing market starts improving. But that could be six months or a year from now. Who knows? So why look at this chart now?
One way to play a rolling stock is through options. I wouldn't invest my money as a swing trade and buy the full price of the stock. But what about an option play? You could buy a July Call option on PHM, meaning that you are counting on the price going up within the next six weeks. If/when the price reaches the top side of the S/R line, then you either convert your option to stock or just sell the option at a profit. Using an option play allows you to minimize your risk, minimize your equity involved, and yet (hopefully) profit from the pattern you've picked out. (The $9 July Calls went for 80 cents yesterday, a 45% one-day gain!)
The third stock we'll look at is XCO. Here's the chart:
This chart uses 30-minute candles and it shows how XCO gapped up on the morning of June 1st and it has been in a downward move ever since it met resistance on June 1st. That candle becomes the first point on our downward sloping trendline.
On June 2nd, it tried to cross the mid-line of the Bollinger Bands but then retreated.
On June 4th, it crossed the mid-line but then found resistance at the top side of the Bollinger Bands.
And yesterday, on June 5th, it met with resistance again, right where the trendline and the mid-line of the Bollinger Bands intersects. (I've drawn a green circle there to highlight the area of resistance.)
So, what do you do with this information. Is this a repeating pattern for gap up stocks? No, not really. But if you are day trading long a stock that gapped down (as XCO did on Friday), then it might be instructive to take a step back and look beyond just that day's 5-minute chart. Get a little wider perspective. Gauge the strength of the rest of the market. And the question you'll ask is "How likely is this stock to cross this line of resistance at this particular time and in this particular market?" And your answer yesterday would have been "not likely".
So, three charts for you to consider. We looked at S/R lines and how they can impact your swing trading, option trading, or day trading activity.
Hope your trading is going well.