The concepts of support and resistance are essential when selecting entry and exit points for trading a trend. These are not esoteric theoretical concepts for notions based in voodoo or some other mystical realm. They are reflections of the repetitive nature of market participation. First of all, let us talk about a resistance level in an uptrend, as illustrated in the below figure.

At point A, traders operating without knowledge of when best to enter a trend buy in. Instead of receiving a price appreciation, however, they see the price fall after their purchase. Feeling sore, they look for an exit that limits the damage to their capital. That point comes at B, when they can get out even, which most people will settle for when they have a negative perception of the position they hold. This then causes a wave of selling when those that purchased at point A decide to get out. This cycle can go on and on. If there are sellers at the resistance level, it probably means that there were members of the public buying at that level and the cycle can repeat.

The obvious question is why the buyers at point A did not cause a further price appreciation? The reason is that trends always move in a zig-zag formation, and there were more eager sellers than willing buyers in the public at that time. As a technical analyst, you don't care why this happens, you merely note the effect and try to profit from it. Support occurs when the price action takes a security down to a level where there are willing buyers in the public. This can happen for various reasons. Buyers may come in to cover short positions that did not work out as intended and seek to get out even, just as long holders did in the uptrend discussed previously. It can also be that for whatever reason, the stock is perceived as cheap once it has reached that level. Again, there can be many reasons, and we are only interested in trading the effect, as and when it happens.

Another important effect to be aware of is that support becomes resistance if that support level is broken. Consider the below figure.

In this figure, we see the usual downward zig-zag formation of an established downtrend. At point A, we can imagine some traders thinking that the security has gone as low as it should and that the trend is reversing (these are clearly not disciplined technical analysts), and they buy the security. The security rallies briefly, but the strength of the trend carries it lower and these traders find themselves in a losing position. When the security rallies briefly, the traders look to get out even, so as soon as the price reaches their initial entry point, they exit in a wave of selling, pushing the security down further.

Support and resistance levels can arise from many other causes. The trendline itself is important as a support or resistance indicator. The greater the number of times the price action has bounced off a trendline, the more significant a break of that trendline becomes. What this means in terms of concrete action taken by day traders is that if you have a position in a security that has seen more than six bounces off a defined trendline, any break of that trendline should immediately trigger liquidation of that position. The breach of a long-established trendline tends to be followed by a rapid move in the opposite direction of the recent trend. In addition, round numbers can become significant levels in a stock's price action. Under certain market conditions, the fact that there are lots of bids at a certain level can create support; conversely, a lot of stock offered at a certain ask price can create resistance. This is by no means the whole story, as we will see in Chapter 4. Round numbers as support or resistance certainly ranks as a secondary effect. Day traders should be aware of it, but not driven to action by it.

These levels of support or resistance are used to time entry and exit points in trends. We have already discussed the correct place to enter a trend: on a pullback to resistance. Should the expected bounce in the price action not take place immediately, however, at what stage should traders close their losses? That question has no definitive answer; it depends on many factors at the time of the trade. The main concern is that we believe the trend to have been broken by the unexpected move. When we are convinced of the break, the time is right to cut our losses. When entering the trade, it is wise to have a level in mind that will trigger you to cut your losses. If that number is reached, you will invariably do best by exiting immediately.

When we are in a trend and see it weakening, there is also a decision to make as to when to lock in profits. During Phase 1 trading, if I have a long position, I usually exit a position at the first sign of a slowdown in the buying of that security. During Phase 2 trading, however, if I have correctly bought into a trend and see immediate price appreciation, I allow the trend to mature and test the trendline on pullbacks in anticipation of further gains. In general, I do not let the price drop more than a 1/4 past where I perceive the trendline to be without closing my position in these circumstances.