SUPPORT AND RESISTANCE LINES WITH CANDLESTICKS

Exhibit 11.1 shows an upward sloping support line. It is made by connecting at least two reaction lows. This line demonstrates that buyers are more aggressive than sellers since demand is stepping in at higher lows. This line is indicative of a market that is trending higher.

Exhibit 11.2 shows a downward sloping resistance line. It is derived by joining at least two reaction highs. It shows that sellers are more aggressive than buyers as evidenced by the sellers willingness to sell at lower highs. This reflects a market that is trending lower.

The potency of a support or resistance line depends on the number of times the line has been successfully tested, the amount of volume at each test, and the time the line has been in force. Exhibit 11.3 has no candlestick indicators that are worth illustrating. It does represent one of the major advantages of candlesticks, though. Whatever you can do with
a bar chart, you can do with a candlestick chart. Here we see how a basic head and shoulders neckline could be drawn on the candlestick chart just as easily as with the bar chart. We will also do in depth trendline analysis.

Exhibit 11.4 illustrates that the lows in late March (near $173) formed a support area that was successfully tested in late April. This successful April test of support had an extra bullish kicker thanks to the candlesticks. Specifically, the three sessions on April 20 to 22 formed a bullish morning star pattern.

Exhibit 11.5 has a wealth of information about using trendlines with candlestick indicators. That includes:

The emergence of support line 1 (late January-early February) shows that the two lows on January 29 and 31 were the initial two points of this line. A third test of this line of February 7 was also a bullish hammer. The combination of these two factors gave a bottom reversal signal. For those who bought at this area, the hammer’s low could be used as a protective stop out level.

The emergence of support line 2 (mid-January-early March) is more important than support line 1 since it was in effect longer. On March 2, the third test sf this line was made by way of a bullish hammer. Since the major trend was up (as shown by the upward sloping support line 2), the bullish hammer and the successful test of support conformed to a buy signal for March 2. Protective sell stops could be positioned under the hammer’s low or under the upward sloping support line 2. A puncture of this support line would be a warning that the prior uptrend had stalled. The harami gave the first inkling of trouble.

This example illuminates the importance of stops. There were numerous reasons to believe that the market was going higher when it tested support line 2 via a hammer. Yet, the market pulled back. You should be confident when the trade is placed, but always take into account doubt and uncertainty. One of the most important concepts in trading–especially futures, is risk control. The use of stops is synonymous to risk control.

Exhibit 11.6 shows dark-cloud covers 1 and 2 produced a resistance line. Dark-cloud cover 3 intersected at this resistance line and thus confirmed this line’s importance as a supply area.

Exhibit 11.7 shows that there was a rally (not shown) that stopped at A. This area provided a preliminary resistance area at .6419. A long-legged doji arose at B. The fact that this doji also surfaced near the resistance level set by A was a reason to be cautious. Points A and B gave the first two points of a resistance line. Traders who use hourly charts would thus look for failed rallies near this line to take appropriate action-especially if they got a confirmatory bearish candlestick indicator. At C, there was a long-legged doji (like the one at B) near the resistance line. The market then backed off. At D, the white candlestick with a long upper shadow was a shooting star. It failed at the resistance line. This white candlestick was immediately followed by a black candlestick that engulfed it. These two candles constituted a bearish engulfing pattern.

Exhibit 11.8 shows two engulfing patterns where pattern 1 was a warning to longs. A few weeks later, the second bearish engulfing pattern emerged. The highs on engulfing pattern 2 also were a failure at a resistance line.

Exhibit 11.9 shows an upward sloping resistance line. It is a trendline that connects a series of higher highs. While not as popular as the downward sloping resistance line in Exhibit 11.1, it can be a useful device for longs. When the market approaches this kind of line, longs should take defensive measures in anticipation of a pullback. These protective measures could include taking some profits on long positions, moving up a protective stop, or selling calls. Although pullbacks should be temporary (since the major trend is up), the failure from this line could be an early and very tentative indication of the beginning of a new downtrend.

Exhibit 11.10 is a downward sloping support line. This is another type of line not used very often, but can occasionally be valuable for those who are short. Specifically, the downward sloping support line is indicative of a downtrend (as gauged by the negative slope). Yet, when the market successfully holds this kind of support line, shorts should take defensive measures in preparation of a price bounce.

In looking at Exhibit 11.11, our first focus is on the downward sloping support line (line A) as previously illustrated on Exhibit 11.10. Connecting lows L, and L, provides a tentative support line. Candlestick L, almost touches this line before prices rebounded. This proved the validity of the support line. The lows at L, were not just a successful test of this downward sloping support line, but they formed a bullish piercing pattern. It was time to cover shorts-or at least take defensive measures such as lowering stops or selling puts. It was not time to buy because the major trend was down (as reflected by the bear channel defined by downward sloping line A and the dashed resistance line above line A). In this case, it turned out that the low at L, was the start of a powerful bull move that only ended with the appearance, a few months later, of the long-legged doji (a rickshaw man since the opening and closing were in the middle of the range) and the hanging man. Note the second piercing pattern on October 19 and 20.

Next, still looking at Exhibit 11.11, let us look at the upward sloping resistance line (line B) as previously shown in Exhibit 11.9. The price activity from January 15 reflects a market that is creating a series of higher highs. Based on this (and the dashed support line), one can see that there is a bull trend in force. The failure on March 6 at a upward sloping resistance line gave a signal for longs to take protective measures. Notice this third test at this resistance line was a shooting star line with its attendant very long upper shadow and small real body. The three days following the shooting star were hanging-man lines or variations thereof. This combination of factors, a pullback from a resistance line, the shooting star and the hanging-man lines gave clear warnings that the market would soon correct.