Look Before You Leap

Practically anything we do requires us to look before acting, Awareness of your surroundings in all instances can mean the difference between making a sound decision and a needlessly risky one.

An NFL quarterback must not only read the defense before calling a play but must also know where his receivers and blockers are in order to properly execute. A mountain climber making a careful descent down a steep rock face needs to know precisely where each next step will be before taking it, or else risk catastrophe. We're taught at an early age to look both ways before crossing the street. And we most certainly cannot make a trade without first studying the chart in order to understand where the best point of entry exists, provided one exists at all.

There are a variety of trading styles and therefore no single way of approaching a trade. However, one of the most reliable approaches involves buying support and selling resistance. As we've discussed previously and repeatedly, support is an area below the market, consisting of formations of highs and lows at a particular price point, at which a declining stock has a reasonable chance of reversing. Resistance is the same, but to the upside; it's an area where a rising stock has a reasonable chance of reversing. The trick with trading successfully against support or resistance is being able to gauge which areas will be most reliable given the overall climate of the market. For example, you may see an area of support on your chart at one price point and then another area a couple dollars lower. If the market happens to be relatively strong, then the higher area of support might be the proper one. But if you're buying dips in a down trending market you'll certainly want to aim for the lower level of support. Setting your sights too low in one type of market might cause you to miss out on a trade while setting your sights too high in another type of market could get you involved in a losing trade.

Think about an outfielder tracking a fly ball. It never ceases to amaze me how a major league outfielder can so gracefully chase down such a tiny ball so high in the sky, gliding across so much ground at high speed, and so effortlessly make the catch. When a ball is hit deeply into the outfield, the outfielder knows to back up, but how far he backs up will depend on exactly how hard and far the ball is hit. If the ball is likely to travel 380 feet all the way to the outfield wall, the outfielder won't make the catch if he only backs up to 280 feet. In fact, the ball will sail right over his head and turn into an extra base hit when it should have been a routine out! If the batter ends up hitting a little flare that will drop into the shallow part of the outfield at 220 feet, then the outfielder needs to know to run in in order to make the catch, and certainly not to back up to 380 feet.  Making the catch in an expansive outfield depends on judging how far the ball will travel. It's one thing to know whether or not you have to run in or run out in order to make the catch, but exactly how far is the difference between success and failure. By the same token, it's not incredibly difficult to simply spot support and resistance on a chart. However, judging the appropriate areas of support and resistance based on the specifics of the market, just like an outfielder must accurately judge the trajectory of a flyball, will determine the winning trades from the losing trades.

Properly planning a trade requires you to identify formations on which you can potentially base the trade and you can find those formations by simply looking to the left on a chart. Yet, the actual areas that you key in on often depend on your time horizon.

Investors, or longer-term traders tend to focus more on historical data and areas of support and resistance that can be found on a daily chart, for example, which may have occurred months or even years in the past. Day traders, who take short-term positions for quick gains, will study the daily charts as well but will pay more attention to the intraday charts, such as a 5 or 15-minute chart, in order to spot the more immediate formations that can yield winning trades. In either circumstance the trader looks and studies in order to become aware of the areas and patterns that will inform his or her trades.

We constantly look at charts so we can anticipate what might come next and the seasoned trader knows just what to look for, taking into account both technical and fundamental factors affecting the markets. As much as we look for the information that tells us when to trade, we look for the information that tells us when to be out of a trade or when not to trade. 

Coming off of a high above $198, it might have been worth a trade to try airplane maker Boeing (BA) against a low it had made just below $187. In many cases, an $11 move from the high would offer a chance to get long, especially if the market seemed to still be strong. However, once BA broke that low, look out below! Notice on the chart how there was no support beyond that? That is confirmation that you should not only be out of a trade, but to not even attempt buying until you get some sort of reasonable formation. As you can see, it was straight down to around $174, a price at which BA may be forming-up to allow for more buying. Could you have gotten short at any point rather than buying at all? Of course! There were plenty of opportunities to try selling starting from the $198 high, as there was clear resistance in multiple places on the way down. You could have been a huge winner if you had the wherewithal to ride the momentum for all that it was worth (not to be a hindsight millionaire).

Making a trade without areas of support and resistance is like cleaning the gutters of your roof without using a ladder. You need something to grab onto in order to safely make it up and down. Chances are, once the stock you're trading gets past any areas of support or resistance that you see on the chart in front of you, it will blow right through whatever reasonable areas you might have noticed. Often times, if we look to a chart with a more historical timeline, such as a different intraday chart or a daily chart, we can see the reason why a stock might have stopped, and those are charts that you must also consider in order to more thoroughly plan a trade.

Luckily for us as traders, if we happen to "fall off the ladder" so to speak, we have stops in place that can rescue a losing trade from becoming an absolute disaster. Remember, you can make any trade at any time as long as you have a proper stop in place. But there are tricks to knowing which areas will yield a trade that might end in a stop out and which will likely hold and lead to a profitable transaction. All of that is revealed in the charts and when the chart you're working with doesn't offer you anything to grab onto by way of support or resistance, you probably shouldn't be making a trade at that moment at all.