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Trading 101

Trading 101: Charting Tools I: Support and Resistance Levels

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So far, we have been looking at trends and the structure of trends in financial markets that are essential in understanding how asset prices move. We also got a glimpse of the art of charting, the visual representation of prices. Now that you have the basic knowledge, we will give you more tools to tweak your trading, while helping you in finding precise entry and exit points. First, we will take a look at support and resistance levels.

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Significant Price Levels and the Memory of Markets

Important levels in the DOW Jones Index, Daily Chart

Everyone who is involved in trading and investing is familiar in one way or another with some of the most iconic levels of the major assets. The $100 per barrel level in crude oil, the DOW 10,000 or 20,000, the 1.00 level in the EUR/USD currency pair—all of these have sparked emotions worldwide, triggering euphoric or apocalyptic visions of profits, inflation, or even wars.

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This level of attention and emotion creates extreme situations in markets, but if you take a step back and look at the phenomenon objectively, you will realize that it is the opposite of extreme—it’s perfectly normal. We, humans, use anchors to help us in navigating in the world; it’s just natural that round numbers and special levels have a prominent role in financial markets. This role usually means that more than average players are selling or buying at those levels, creating resistance and support levels respectively.

So what kind of special levels are there exactly? Here is a list containing the most important ones:

  • Round numbers
  • Previous swing highs and swing lows
  • All-time highs and all-time lows
  • Previous opening and closing prices
  • Fibonacci-levels
  • Range projections

The “memory” of the markets means that previously important levels (like extreme points in the price of assets) will remain later on. Of course, this effect might get weaker by time, but sometimes certain levels from years and years earlier retain their role as support or resistance levels. You probably noticed the previously mentioned swing highs and swing lows in the list and, of course, all-time highs and lows are also swing highs and lows by definition. This could shed more light on why those highs and lows are crucial in swing trading strategies.

Out of these levels, Fibonacci levels and range projections need some explanation. We will talk about range projections in the second half of this post, but for now, for those who don’t know them, “Fibo” levels are “natural” retracements and extensions for a given price movement. They are calculated using Fibonacci numbers and the Golden Ratio that is found everywhere in nature from the shape of galaxies to the geometry of plants. Later on, we will dedicate a whole post to Fibonacci levels.

Using Support and Retracement Levels in Trading

Support and resistance levels are very versatile tools that can be used for both primary and secondary trading signals. The basic premise of these levels is that there is a significant amount of buying power or supply concentrated near them. When the price of an asset gets close to these levels, they “test” the power of the trend with that additional demand or supply.

What does this mean for you as a trader? These levels are possible turning or breaking points that generally lead to heavy trading, significant moves, and sometimes major trend reversals. It is important to note that the underlying trend always deserves priority—in an uptrend support, zones generally hold, resistance zones generally fail. Just because an uptrend runs into resistance or a downtrending asset finds support, the trend won’t change. That said, if other clues suggest a trend change, these levels frequently provide the trigger for the reversal.

Primary Signals

Break-out trades in an uptrend

Using these levels to enter a trade is the most effective in the direction of the prevailing trend. As an example, if an asset is in a counter-trend move within an uptrend, a nearby support level could be a good place to buy the asset. Also, if the same asset breaks through a strong resistance zone (see the chart above), it is likely that the trend will continue (of course other factors should be considered as well).

To understand this even more, imagine those traders who are speculating on a trend reversal using the said resistance level. Those players will likely exit their positions as the price rises above the resistance, actually providing additional buying for the asset! That’s why break-outs often lead to explosive moves in uptrends, while support breaks lead to steep losses in downtrends.

Secondary Signals

Support and resistance levels are also great to select optimal profit-taking and stop-loss orders. Using an uptrend as an example again, if the price of the asset drops below a certain support level that sometimes means that the trend is weakening, at least short-term. Also, if the price approaches a resistance zone, the odds for a correction increase, possibly justifying taking profits, or fully exiting the position depending on other factors.

Trading Ranges and Range Projections

As we stated previously, asset prices spend a lot of time in neutral trends, trading without a clear direction. These consolidation phases mainly happen in trading ranges or other consolidation patterns. A trading range is a zone that is bordered by generic horizontal resistance and support levels. Other consolidation patterns might have different shapes, such as triangles and wedges. We will dive deep into these chart formations in our next posts.

The “classic” range consolidation is a great formation for trend-following strategies, as the borders of the range provide easy-to-identify primary and secondary signals for traders. Another important usage of these ranges is range projection, a technique to identify trading targets using the size of the trading range.

How does that work in practice? The most common method is to project the size of the range in the direction of the break-out and set trading targets according to this possible new resistance or support level. The memory of the markets, in this case, means that traders and trading robots are “used to” the prior size of movements, and as the price approaches the projected level they will assume that the movement will soon end, which will be also suggested by a lot of indicators that were “calibrated” in the prior range (we will explain this effect later on in our posts on indicators).

An example of the range projection method

These projections are usually more effective in the case of long-lasting trading ranges. Also, sometimes it is useful to use secondary range projections as well, doubling the size of the original range, as resistance levels frequently develop near these projections.

False Signals

As it’s the case with everything in trading, support and resistance levels are not perfect. A lot of times (especially in the days of trading algorithms) the price “overshoots” these levels, as trading robots go wild near these key points. These spikes sometimes lead to false break-out or break-down signals. The good news is that if you are aware of this process, you will be able to benefit from it, even if sometimes you will inevitably be the victim of these “traps”.

Again, respecting the prevailing trend is vital. False break-outs above resistance levels are much more likely to happen in a downtrend than an uptrend, and similarly, break-downs in uptrends are not to be trusted, as they commonly prove to be bear-traps.

False signals in a trading range, within an uptrend

When you are using these levels for trading, especially as secondary signals, it is often a good idea to leave some ground for these false moves by setting the stop-loss or profit taking orders, a bit away from the exact support or resistance levels. Also, buying an asset after a false break-down, or shorting it after a false break-out, is among the highest probability trades out there as those who got trapped will likely exit their positions as the market moves against them.

In our next post on charting, we will take a look at some notable chart formations including tops, bottoms, consolidation patterns, and much much more.

Previous article: 10 Essential Trading Rules for Rookies

Important: Never invest money you can't afford to lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here.



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4 Comments

4 Comments

  1. vjnunez

    April 29, 2017 at 8:01 pm

    Love this series of 101 trading, keep them coming 😉

    • Mate Cser

      April 30, 2017 at 3:04 am

      Thanks! Great to hear that you enjoy the series! Stay tuned for much more!

  2. sambkf

    May 4, 2017 at 10:23 pm

    Great post again. Technical however easy to access !

    • Mate Cser

      May 5, 2017 at 12:46 am

      Thank you for your comments, and of course, if you have any questions, don’t hesitate to ask!

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Trading 101

Why I Switched to Momentum Investing

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Momentum investing

After sticking to various reversal trading strategies for a while now, I have started to look more into momentum and trend when it comes to investing in stocks specifically. Some people may find the idea of momentum a bit strange to begin with, and it is only after watching individual stocks, while also keeping an eye on the movements of the overall market, that you rally understand its meaning.

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Seasoned stock investors, especially those that adhere to value investing, are often skeptical towards the idea of buying a stock that has already increased in price. It basically goes against their instincts of buying low and selling high. However, as people start to understand the mechanics of it, they tend to change their opinion.

Never catch a falling knife

An unwritten law in any market is that a trend tends to continue. Hence, if a stock has been moving up three straight months, it is more likely that it will continue to move up for a fourth month instead of turning down. A “cheap” stock can always become cheaper and an “expensive” stock can always become more expensive. These are well-known principles that explain the basics behind why momentum and trend trading works, and it is the idea behind old cliché’s like “never catch a falling knife” and “cut your losses, let your profits run.”

Over time, however, any financial asset has a tendency to revert to its mean. As such, when a trend has been overextended, a reversal in price can be expected to follow. This is the idea behind reversal trading. However, it is important to understand that it can take a while for this to happen, and you may very well get wiped out in the process.

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The trend is your friend

The concept of buying stocks on their way up makes a lot of sense from this perspective, as you are then buying something that the market is starting to like, which is about to be valued higher. Trying to catch the falling knives is simply to risky from a risk:reward perspective, and in my opinion it should be avoided altogether. Why would you buy a stock that is falling when you instead can buy it at its way up?

Still, there are situations that arise in the grey areas, where a stock seems to have gone so low that it can do nothing but go up again. It may be tempting to give it a try, but remember that this is an extremely difficult thing to do, and the stock may just as well continue its steady decline. When the stock finally turns, there will still be plenty of time for you to jump on the bandwagon.

Mining companies, some companies within the maritime shipping industry, and the entire Japanese stock market are all examples of great bargains from a value standpoint, where the investor would sometimes have to wait for decades to earn his initial investment back. Don’t fall into this trap by picking stocks that are still falling and appear “cheap.” Don’t try to outsmart the market.

Combining momentum with value

Value investing

In my opinion, a killer long-term strategy in the stock market is to combine sound value-investing principles with momentum. In other words, you should look for undervalued companies that have been badly beaten up for years, and that are just starting to turn. Oftentimes, this is where the greatest potential is and I believe it is one of the best ways to beat the index over the long term.

We can find two examples of how well value investing with momentum works in the US after the stock market crashes in the mid-70s and the 2008 financial crisis. Following these two events, only value investing yielded a clearly higher return than value combined with momentum.

However, if you were a value investor before the crash started, chances are you would get wiped out before the market finally turned. If, on the other hand, you were a value investor with momentum as one of your criteria for holding, you would automatically get rid of all the stocks that were in decline, and instead buy them again after the crash was over.

Because of this, momentum indicators like the MACD can be of great help when making these investment decisions. When combined with value-principles, you have a killer approach to long-term success in the stock market. I’m definitely looking more into crafting a robust investment strategy based on this for myself, and I will come back and share more specifics on potential strategies later.

Featured image from Pixabay.

Important: Never invest money you can't afford to lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here.



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Trading 101

Trading 101: Intro to Forex Trading

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Forex trading

When you are first getting introduced to the world of forex trading, things can seem a bit overwhelming. There is so much information available online, but very little of it is aimed at beginners who may not be familiar with the terms and concepts they refer to. In this article we will cover the basics of forex trading, explain the most important terminology, and tell you how you can get started trading forex for yourself.

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Forex jargon

To start off, let’s define some terms. Forex stands for “Foreign exchange” and is the name often used for this market where traders can buy one currency by paying with another currency. Other names used for this is the “FX market” or the “currency market.”

A pip, often referred to as “point in price”, is simply the smallest price move that is possible in a given currency, also known as a basis point. Forex traders often talk about their gains and losses in terms of pips instead of percentages or monetary values.

Long/short are confusing terms that often get tossed around by forex traders as well as other traders. To put it simply, long means that you are buying an asset and will make a profit if that asset goes up in price. Short, on the other hand, means that you are trying to make a profit from declining prices. The way it works is that you sell an asset that is borrowed from another market participant. After the price has dropped, you can then buy back the asset in the market for a lower price than you sold it for, and thus make a profit.

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Stop-loss is the level a trader decides on where he would like to exit his trade if it is not working out for him. In other words, it is the maximum loss the trader is willing to take on one particular trade. Alternatively, a stop-loss order can be used to secure a profit on a profitable trade in case the market turns.

Leverage is the practice of taking a larger position in the market than your trading account size would otherwise allow. Basically you are borrowing money from your broker in order to boost your buying power in the market. Leverage offered in the forex market is often in the range of 200-400:1

Spread, also known as bid-ask spread, is the difference between the buying and selling price of an asset in the market. The broker will offer you to buy a currency at a slightly higher price than they will let you sell that currency. This is where brokers make most of their money, and it is important to compare spreads when choosing a forex broker.

Currency pairs

Since the forex market works by participants buying one currency with another currency, the price of a currency must always be quoted in another currency. For example, when you see that EUR/USD is trading at 1.20, it means that you need 1.20 US dollar to buy 1 euro.

The worlds largest market

The forex market is known as the largest of the world’s financial markets. Approximately $5 trillion changes hands in the forex market every day, far surpassing the global stock markets and commodities markets.

It is important to understand that the trading activity that retail traders (traders like you and me) account for is just a small, but rapidly growing, share of the total activity in the forex market.

Fundamental or Technical Analysis

When you are deciding to become a trader, you also need to decide on what type of trader you want to be. Broadly speaking, there are three types of traders; fundamental traders, technical traders, or a combination of the two.

Fundamentals take into account news, valuation, interest rates, etc. when trying to determine what price a currency pair “should” be trading at.

Technicals, on the other hand, focus strictly on what the price of the currency pair is doing. Technical traders study and analyze price charts to try to determine the future direction of the price.

Majors and Minors

Forex traders often talk about majors and minors when referring to currencies. Majors is a list of the most actively traded currency pairs in the world, and it consists of these pairs:

  • EUR/USD: The euro and the US dollar.
  • USD/JPY: The US dollar and the Japanese yen.
  • GBP/USD: The British pound and the US dollar.
  • USD/CHF: The US dollar and the Swiss franc.

Forex majors often have the lowest spreads in the forex market and they are also among the most liquid instruments you can trade in the financial markets.

Forex minors is a list of the next most actively traded currencies. This list includes currencies such as the British pound (GBP), Canadian dollar (CAD, aka “Loonie”), Australian dollar (AUD, aka “Aussie”), and New Zealand dollar (NZD, aka “Kiwi”).

Lastly, there are the exotic currency pairs. These include the remaining currencies from European countries outside the Eurozone (NOK, SEK, DKK) and smaller yet important Asian currencies like the Singapore dollar (SGD) and Hong Kong dollar (HKD). The exotics have less trading activity and the spreads are usually higher than for the majors and minors.

Benefits of Forex Trading vs. Stock Trading

A benefit of trading in the forex market rather than the stock market is that the forex market is trading 24 hours a day, from Monday morning in Australia until Friday evening in North America. The great thing about the market being open 24 hours is that there are no overnight “gaps” like you can find in the stock market.

A gap simply means that the market opens at another price in the morning than it closed the night before. For traders, gaps are considered a big risk, since the trader cannot control what is happening with his trade while the market is closed.

A market that is open 24/5, like the forex market is, opens up great opportunities for medium-term traders (swing traders) to for example take positions during the beginning of the week and exit those same positions before the week is over. That way, the trader takes no risk over the weekend when the market is closed.

Additionally, the forex market is much more liquid than most stocks, and it’s easy to find technical and fundamental analysis of this market everywhere on the Internet.

Choose a Forex Broker

Once you have decided to give forex trading a try, you need to choose a good broker that you trust with your money. This is the first, but still a critical step, on your way to become a successful trader. Pay particularly close attention to regulation, withdrawal policies, spreads, and trading platforms offered when choosing your broker. Fore more on this, read our earlier article on how to choose a forex broker.

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Trading 101

Trading 101: Moving Averages and Moving Average Strategies

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What are Moving Averages?

Moving Averages are among the most popular trend indicators in Technical Analysis. They provide a simple, yet powerful visualization of the ongoing trends in an asset. They are used for a wide variety of reasons, primarily for trend following and reversal strategies.

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Simply put moving averages are connected points calculated for every day (or whatever the timeframe is). The calculation itself is simple; you take a given number of previous days and calculate their average. Of course, you don’t have to do the calculations yourself. All basic charting software and trading platforms do the math for you and plot the moving average (or up to dozens of averages for that matter) on the chart of the asset.

How to Interpret Moving Averages?

(more…)

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