Trading 101: Support, Resistance, And Divergence

08/07/09 01:04:48 PM

by Donald W. Pendergast, Jr.

Sometimes, a seemingly perfect trade setup appears, one that deserves a second look. Here's a look at one such intraday setup and the real-life trade that followed.

Security: ESU9, .SPX, SPY
Position: N/A

Anyone following the major market indexes probably knows that the Standard & Poor's 500 had risen for 15 of the 18 trading sessions prior to today (Thursday, August 6, 2009), gaining about 16% in the same time period. It was therefore little wonder to see the index sell off fast during the morning session, dropping down to test an important intraday support level. Here's a description of the trade setup and the trade that was taken, hopefully providing newer traders with some insights as to why trading near critical support and resistance levels can be so profitable. See Figure 1.

FIGURE 1: EMINI, THREE-MINUTE. After three successful tests of an intraday support level (S1), the emini finally acknowledges the massive bullish price-momentum and price-money flow divergences that had been developing for three hours.

Graphic provided by: Interactive Brokers TWS 3-minute chart.

When Thursday's session opened, the bulls quickly pushed prices up to the 1006.00 area, quickly losing control as a heavy round of selling pressure drove the September 2009 emini S&P 500 contract (ESU9) down by more than a dozen points in less than an hour to the red horizontal support/resistance line near 993.00 known as S1. Such a selloff was not a real surprise to professional traders who deal in this market everyday, especially since they know that even the strongest bull markets need to stop, pause, retrace, and consolidate before hopefully moving higher again. The contract managed a decent pullback over the next hour or so, managing to momentarily pierce the 999.00 area near the daily floor trader's pivot point (the gold horizontal line, or PP) before dropping once again down to test S1. This was about the time I started to give this chart some serious consideration, mostly because of the way in which the momentum (9) and Chaikin money flow (CMF) (21) indicators were showing signs of significant bullish divergence with the price action on the chart.

I glanced at the NYSE advance-decline (A/D), up volume-down volume, TRIN and tick numbers at that point, but the A/D figures were inverted (decliners were outnumbering gainers by a wide margin), so I decided to hold off on an entry. The contract then staged a feeble rally up to the 50-period exponential moving average (EMA) (purple line) at 0945 Pacific time (PT), quickly turning back to test S1 again. Now things were really getting interesting: S1 managed to hold as key resistance for the third time in a row even as the bullish divergences in both the momentum and money flow indicators was becoming even more pronounced.

After checking the NYSE internals again, I discovered that the A/D ratio was slowly improving, as was the up volume/down volume ratio. Even the tick and TRIN readings were cooperating this time. I decided to get in on a buy-stop at 994.75, which was a price just above the 20-period EMA (thin silver line) at about 1012 PT. I placed a mental stop just below S1, realizing that a possible break below this support level now was going to follow through with substantial selling.

My target for the trade was modest, as it always is on a three-minute chart -- one full point. In 14 minutes, my sell limit order of 995.75 was hit and I was out of the trade with a modest profit. Drawdown during the trade was very modest, about one point. Identifying a major intraday support level in conjunction with a significant bullish divergence situation allowed me to get positioned for a low-risk scalp trade, one that had a fairly high probability of success.

FIGURE 2: NYSE. Monitoring the internal strength of the NYSE is critical to successful intraday trading of stocks and stock index futures contracts like the emini S&P 500. Note the weak advance/decline ratio, even though the rest of the stats are very bullish.

Graphic provided by: Interactive Brokers Market Statistics screen.

Figure 2 depicts the internal strength of the NYSE at the time of trade entry. Note that although the up volume/down volume ratio was very bullish, the advance/decline ratio was not supportive of a significant intraday rally at that time. The tick and TRIN readings were well into bullish territory, however. Unless all four of these internal market strength indicators are in sync, it would usually pay to assume that the market is in some sort of a trading range until proven otherwise. In such cases, going for small scalp profits is probably a much more appropriate strategy than trying to hang on for a major intraday move.

The lesson of this article is basic enough; any time you see an area of chart support that repeatedly turns back price (three or more times is better), you need to start evaluating the rest of the chart's technicals for a possible entry trigger in subsequent bars. If you see a major bullish price-momentum and/or price-money flow divergence appear at the same time, your odds for success trading the long side of the market will increase dramatically. Pull up some of your favorite charts and see how many of them are manifesting a technical setup similar to what has been presented in this article. You may be surprised at how many you can find once you know what to look for.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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SUPPORT & RESISTANCE

Trading 101: Support, Resistance, And Divergence

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