The first approach is to buy at support or sell at resistance. A benefit of this technique is that you can set a tight stop loss point just beyond the support/resistance level. If the trade goes in your favour, you often make profits several times greater than the loss you incur if the stop loss order is triggered. This ensures that the Average Win to Average Loss ratio is favourable. If you get good at choosing trades so that the probability of a win is 50% or more, you are onto a winning formula.
In all trading it is vital to go with the market flow, not fight it. If the market is rising, BUY – don’t get trapped into thinking it can’t go higher and must be due to fall. The converse applies in falling markets. In rising markets, go long. In falling markets, go short. It seems obvious, doesn’t it? This idea is embodied in the trading adage: “The Trend is My Friend”.
Now, selling at resistance or buying at support means that you are going against the short term trend. It must be so. If the market has been rising towards resistance, and you sell, then clearly you are betting that the current short-term up trend will reverse and prices will fall. Conversely, if the market has dropped to a support level and you buy, then you are gambling that prices are going to turn round and start going up again. Isn’t this in conflict with the basic principle espoused in the previous paragraph telling us to trade with the trend? The answer is that it is, so care is required with this technique.
The most important thing is to ensure that you are trading in the direction of the long term trend. For example, you may see that the daily chart of some commodity is dropping towards a clearly defined support level on the charts. Will it bounce there, or will it drop right through it? You can not know for sure, but if you see that the weekly chart shows prices to be in a solid long term up-trend, then that improves the chances of price bouncing off support and resuming the upward move. Longer term trends have momentum, and often reassert themselves after short term retracements.
It boils down to this. You always want to trade with the trend. But no market goes straight up or down – the progression is often made up of a series of waves, each pushing further in the direction of the trend before pulling back to gather strength prior to another surge. For example, if hourly charts show a market has been steadily rising for a few days, and you see a pullback on the two minute chart to a support level, then that is a potential candidate for a long trade. You have a good entry at (or just above) the support level, with a tight stop loss just below the support level, and you are trading with the longer term trend.
As it is not possible to know how long the dominant trend will persist, it is wise to manage trades of this nature utilising trailing stop loss orders. In other words, the stop is trailed as the trade moves favourably. Be careful not to place the stop too close to current prices, or a good trade may be prematurely stopped out by random market fluctuations. The best idea is to ensure that the current stop is always located below the last significant support level.
The second approach is buy on a break of resistance, or sell on a break of support. This has the benefit of entering the trade in the direction of the short term trend. So, if the market drops to support, and penetrates that support level, you sell. Conversely, if prices rise to a resistance level, and penetrates it, you buy. As with the first approach, you can improve the odds of success by restricting trades to those breakouts which are in the direction of the longer term trend. In this case you have the ideal situation where the short term and long term trends are aligned.
Applying this technique often requires a wider stop loss than the first approach. While it may seem that a break above resistance should provide a good stop loss point just below the resistance level, in practice it is better to put the stop loss below the previous support level. As a consequence of this, the win/loss ratio tends to be less favourable than with the first approach.Trade management in this scenario can be either the trailing stop loss approach, or by specifying a target. Some traders use a combination approach, trailing stops until an ambitious target is achieved, or they are stopped out.
Management with trailing stop loss orders often yields the highest Expectancy in the long run, but the probability of a win may not be very high and returns may be volatile. Trade management by setting targets allows more flexibility to tune parameters. For example, large targets result in a lower probability of a win, but a higher average win/loss ratio. Conversely, a small target may have a high probability of winning, but small average win/loss ratio. There is no right answer, other than to ensure positive Expectancy. Choose a method which suits your personality and stick with it.
The approaches described above are not fully defined strategies. To utilise them it is necessary to define strict, unambiguous trading rules. For example, you might define a breakout strategy for trading the Russell 2000 electronic emini contract as follows:
Establish the price range during the first 60 minutes of the main trading session. If, during the second hour, price breaks the high of the initial range, go long with a stop loss one point below the low of the initial range. Conversely, if the price breaks the low of the initial range, go short with a stop loss one point above the initial high point. If neither the initial high or low is penetrated in the second 60 minutes, no trade is taken. In either a long or short trade, a profit equal to the width of the initial range is targeted.
(Note this is not a recommended strategy, it is an example to show how a definite strategy could be built around the breakout approach.)
An infinite number of such strategy permutations can be built round either basic approach. It is the trader’s job to examine charts for the chosen market and develop a winning formula. In the process of researching this subject, you will encounter moving averages, stochastics, Fibonnacci retracements, Elliot wave theory, Williams %R and any number of other indicators that give buy/sell signals. My advice is to ignore them and concentrate on understanding strategies based on support/resistance levels, because such strategies do not filter price action in an artificial manner. That is what the majority of professional traders do.
Good luck!
