The Japanese have a saying that, “a red lacquer dish needs no decoration.” This concept of simple beauty is the essence of a technical principle I frequently use with candlestick charting. It is as simple as it is powerful-old support becomes new resistance; old resistance becomes support. This is what I call the “change of polarity” principle. Exhibit 11.22 shows support converting to resistance. Exhibit 11.23 illustrates prior resistance becoming new support. The potency of this change of polarity is proportional to:
- the number of times the old support/resistance levels have been tested; and
2. the volume and/or open interest on each test.
The concept behind the change of polarity principle (although not traditionally called that) is an axiom discussed in any basic book on technical analysis. Yet, it is an under utilized gem. To see how universally well this rule works let us briefly look at some examples across the various time horizons and markets.
Exhibit 11.24 shows four occasions in which old resistance converted to new support. Exhibit 11.25 shows how the lows from late 1987 and mid-1988 became an important resistance zone for all of 1989. Exhibit 11.26 illustrates how the old resistance level near 27,000 in 1987, once penetrated, becomes significant support in 1988.
To round out the time horizon (we saw this rule in the prior examples with a daily, weekly and monthly chart) let us look at an intra-day chart (see Exhibit 11.27). From early to mid-July, it was obvious where the resistance level set in-at $.72. Once penetrated on July 23, this $.72 immediately converted to support. Once the July 24 and 25 highs of $.7290 were breached, that level also converted to support.
Exhibit 11.28 shows the usefulness of the change of polarity principle. In late 1989 to early 1990 there was a substantial rally. For the first half of 1990, the market traded in a lateral band with support shown as a dotted line near $1.85. When this level was breached in June 1990, what was next support? The price action from $1.25 to $2.05 was essentially straight up so there was no support evident based on the late 1989 to early 1990 rally. Yet, when $1.85 broke, support was expected near $1.65. Where did I get that figure? Two reasons. The first was that a 50% correction of the prior $.80 rally was near $1.65. The second, and more important reason, was the prior resistance at area A was also near $1.65. That should mean it will now be support. A series of limit-down days comprised the June selloff. This selloff stopped at $1.66.
Pick up just about any chart, be it intra-day, daily, weekly, or longer and the chances are high that you will see examples of this change of polarity in action. Why is something so simple so good? The reason has to do with the raison d’@tre of technical analysis; to measure the emotions and actions of the trading and investing community. Thus, the better a technical tool measures behavior, the better that tool should work. And the change of polarity principle is so successful because it is based on sound trading psychological principles. What are these principles? It has to do with how people react when the market goes against their position or when they believe they may miss a market move.
Ask yourself what is the most important price on any chart? Is the
highs made for move? The lows? Yesterday’s close? No. The most important price on any chart is the price at which you entered the market. People become strongly, keenly and emotionally attached to the price at which they bought or sold.
Consequently, the more trading that transpires at a certain price area the more people are emotionally committed to that level. What does this have to do with the fact that old resistance becomes support and old support becomes resistance? Let us look at the Exhibit 11.29 to answer this. In late December, a steep selloff culminated at $5.33 (at A). On another test of this level, there are at least three groups who would consider buying.
Group 1 would be those who were waiting for the market to stabilize after the prior selloff and who now have a point at which the market found support-$5.33 (the December 28 lows at area A). A few days later, a successful test (at B) of this support probably pulled in new longs.
Group 2 would be those who were previously long but were stopped out during the late December selloff. On rally B to B1, in mid-January, some of these old longs who were stopped out would say to themselves that they were right about silver being in a bull market. They just timed there original purchase incorrectly. Now is the time to buy. They want to be vindicated in their original view. They wait for a pullback to support at C to go long again.
Group 3 would be those who bought at points A and B. They also see the B to B, rally and may want to add to their position if they get a “good price.” At area C, they have their good price since the market is at support. Thus more buyers come in at C. Then for good measure another pullback to D draws in more longs.
Then the problems start for the longs. In late February, prices puncture support areas A, B, C, and D. Anyone who bought at this old support area is now in a losing trade. They will want to get out of their trade with the least damage. Rallies to where the longs bought (around $5.33), will be gratefully used by them to exit their longs. Thus, the original buyers at areas A, B, C, and D may now become sellers. This is the main reason why old support becomes new resistance.
Those who decided not to liquidate their losing long positions on the minor rallies in early March then had to go through the pain of watching the market fall to $5. They used the next rally, in early April (Area E), to exit. Exhibit 11.29 illustrates how support can become resistance. The same rationale, but in reverse, is the reason why resistance often becomes support. Do not let the simplicity of the rule fool you. It works-especially when melded with candlestick indicators. For example look at area E. Notice how the doji after a tall white real body meant trouble. This candlestick signal coincided with the resistance line. The same scenario unfolds at F.
In Exhibit 11.30, the highs at A and B then became support in late 1986 and then in 1989. Note how the strength of this support was confirmed twice in 1989 by two consecutive hammer lines.
In September and early October, at areas A and B in Exhibit 11.31, the market maintained a support level near $1,230. Once the bears pulled the market under that level on October 9, this $1,230 then converted to a band of resistance. After the first failure at this new resistance, at C, prices descended until the bullish engulfing pattern. A minor rally then followed. This rally stalled, once again, at the $1,230 level. In addition, there was a dark-cloud cover.