S&P 500's Channel Support And Resistance

12/05/05 12:05:06 PM

by David Penn

A break below the lower boundary of a trend channel finds the S&P 500 running up against resistance that was once support.

Security: $SPX
Position: N/A

I've written about trend channels frequently over the past few years. For me, they are a perfect corollary to the trendline drawing method recommended by Vic Sperandeo in his Methods Of A Wall Street Master. Not only that, but it seems as if every other time I use trend channels -- or read about their use from veteran technicians -- I learn something new about them.

But there are still some basic ideas about these charting tools that I have appreciated fairly early on that continue to inform my understanding of trends, corrections, and reversals. And one of those ideas is the way that the lower boundary of a trend channel, a boundary that provides support during an uptrend, often becomes a source of resistance once penetrated to the downside by prices.

FIGURE 1: S&P 500, HOURLY. Breaking into a new trend channel in early November, the S&P 500 slipped from that channel in late November and failed on its initial attempt to move back into the channel in early December.

Graphic provided by: Prophet Financial, Inc.

Those traders who trade trend channels tend to buy when prices retrace toward the lower boundary and sell when prices rally toward the upper boundary. In a sense, these traders are trading a trend as they would a consolidation, and it is the support and resistance provided by the trend channel's parallel lines that make this strategy possible. However, what happens when such a speculator makes a buy at the lower boundary and that trade goes into the red?

There is a saying that there are good trades and bad trades, profitable trades and losing trades, and that "losing trades" can still be considered "good trades" if (a) the loss is small and (b) the loss is instructive. The first point is simply a matter of trading gospel. But the second is one that is sometimes less emphasized in discussions about "good losses" in trading. What is "instructive" about a loss?

In the case of trading trend channels, the answer is "potentially a great deal."

Consider the hourly Standard & Poor's 500 in Figure 1. Trading the trend channel in late November would have meant buying the index as it pulled back toward the 1256-1260 area. But when prices broke down below the support that "should have" been provided by the lower boundary of the trend channel, many trend channel traders would have elected to cut their losses short at that point.

Here, two possibilities were likely. One, that prices had merely overshot the lower boundary and were about to bounce back. Two, that prices were correcting more significantly, and the trend channel break was a harbinger of further declines.

In either case, the trader who abandoned the position when support was violated would have been in a good position. If prices had bounced back into the channel and again found support inside it, then the trader could have comfortably reentered a long position with the same (or similar) stop-loss parameters (that is, violation of the lower boundary).

But if prices bounced back toward the lower boundary and found it providing resistance, not letting prices back into the channel, then the trader would have the option of remaining on the sidelines or perhaps even going short. In this case, the post-break reaction highs could have served as a stop-loss parameter, with a downside target of the upper boundary of the old trend channel some 20-30 points lower -- albeit getting closer all the time.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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S&P 500's Channel Support And Resistance

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