In today’s episode we will continue with the topic of support and resistance, supply and demand, and combine that with trends, and repeat some of what we learned so far in this series.
We already spoke about trends and trend lines a few weeks ago, so You already know that a trend is the kind of price action that is going to make you money. You will buy at some price, say $10, the price will trend upwards, 11, 12, 13, 14 and you will sell for a profit at $15, as an example. Or you sell short at 100, the price will trend downwards 99, 98, 97, 96 and you will buy to cover at 95 and make money. That’s simple, right?
Earlier we also concluded that the markets move in waves. In an uptrend you will have price moves, or pushes, upwards, and then price moves, retracements, downwards. This is true on every time frame, and in both upwards and downwards trends.
The market never goes straight from one point to another. Even if it sometimes looks like the market moved down in a straight line when you look at a historical 5 minute chart for example, there would have been a lot of fluctuations up and down during that move, especially if you watched the same market in a lower time frame, e.g. 1 minute chart.
So when you have these waves moving higher and higher, this price action will form a trend. And you can use lines to draw simple trend lines, which is the idea behind diagonal support and resistance.
So the idea behind trend lines is straight forward. We just connect the dots. When there is underlying demand for the stock, currency, futures contract or commodity – or whatever you are trading because this is true for any traded security – the prices will increase. The demand forces the prices upwards with certain momentum, until the demand diminishes or a force of supply that is strong enough changes the direction of the price movement. We can see that the demand is diminishing as the price bars or candles arch over of flatten out, consolidate. When this happens over and over again, we will get low points and high points. We will use these to draw the trend lines; the support line in an uptrend together with an Overbought line parallel to the support line.
Then when a growing force of supply becomes significant, it will drive prices downwards, until the force of supply is exhausted, OR if there is new demand coming in. Then prices tend to round up or level out. When this happens a few times in a row, we get two high points that we use for drawing the resistance line and an oversold line, parallel to the resistance line.
Now that we have those parallel line, we see that they form a channel. An uptrend channel or a down trend channel.
The way we can use trend line channels in day trading price action is both as a trading signal, and as a filter – a way to avoid entering trades when the circumstances are not right.
So, like we did in episode 3, we draw a trend line – in this case a support line, or a demand line — there are always many different terms, different market terminology, that is used. I like to use the term support line when drawing a trend line to indicate an up trend. We draw the support line through two lows. Then we draw the overbought line, parallel to the support line, through the high between the two lows that we used for the support line.
In a down trend you use the same principles; you find two highs, draw the resistance line through those. Then find the low between those two highs, and dram a line through it, parallel to the resistance line.
These two lines form a channel, a range, with An upper boundary and a lower boundary, and we expect the market to continue moving inside this channel — until it break out of it. That can happen soon, or the market can stay in the channel for a long time. The significance of trend lines and channels that “fail” is not just that a trend line is broken – but HOW and under what circumstances. A move down through a support line, can just be a test, or it can be a “shake-out”. The Shake-out is a form of market manipulation, where large market operators artificially push the prices down to “shake out” traders out of their positions. In other words, scaring the traders into selling. These price moves are often called springs when they occur in uptrends, and upthrusts when they occur in downtrends. They are usually very good trading signals, but it is difficult to trade them as it will feel counterintuitive to go long when the market seems to go down.
Another way you would use an up trend channel for trading, is either to BUY as the prices bounce of off the support line, and to sell short as the prices bounce off of the overbought line. At the overbought line you want to see prices arch over or flatten out. You want to see shorter, smaller candles and diminishing volume. This signals that the demand is drying up for the time being.
And at the support line you want to see the prices round up or level out. As the price starts to move up, you want to see an increase in volume and bigger candles which tells you that the demand is again becoming stronger.
Another way to use the channel for trading is to sell short as the market breaks the support line. But you don’t want to sell short immediately. That will lead to a lot of losing trades, because there will be false breakouts happening all the time.
You should instead either wait for two consecutive closes below the support line, or better yet, wait for a retracement up to the support line — as the market is likely to try testing these levels again to see if there is still demand to go higher. You want to see a big red candle and high volume on the break out. That tells us that there is a lot of supply entering the market. Then when the retracement occurs, this should be on diminishing volume and candles that get smaller and smaller.
Same thing in a down trend channel. You will want to sell short as the price bounces off of the resistance line, and buy when the price reaches the oversold line. Here you also want to pay attention to the price action and analyze the candles. When the price approaches the oversold line you should see smaller and smaller candles and lower volume, the candles will flatten out and round up. At the resistance line you also want to see prices arch over, and volume picking up as the down move begins.
When the market breaks through the resistance line, you want to see this happening decisively, on a big candle and with big volume. It is safest to wait for a retracement after this breakout, as there is a risk that it is a false breakout or an upthrust that tries to shake-out traders, or fool traders into buying right before the market starts moving down. The retracement should be on lower volume, there should not be any demand, not a lot of buying at this point. The volume should be on the down moves. That tells us sellers are in control, and we want to join those sellers and profit from the down move.
Another way to use the price channels is to know when to be more conservative in your trade management. Say you the market is in an up trend channel, and some day trading strategy like the DayTradeToWin Atlas Line, Trade Scalper or At The Open2 signals a long trade close to the upper boundary of the channel, close to the overbought line. Now you can take advantage of the information that the trend channel gives you and take profits earlier as the market approaches the overbought line, or enter a smaller position in the first place.
Or if you use some less accurate trading strategy, other than the DayTradeToWin strategies, you may even want to filter out trades that signal at the boundaries. Filter out long signals that occur at the overbought line, and filter out short signals that occur close to the support line.
Today we have again talked about volume. The analysis of Volume is one of the foundations and corner stones in price action trading. In the next episode we will go through the basics of volume analysis. It is going to be important for you to know and understand, so please make sure you subscribe so you get access to the next Episode.