by Rick Ratchford
At one of the trading classes, I conducted back in 1997 in North Hollywood; I was demonstrating the use of ratios to discover support and resistance price zones via a chart projected on the screen. After having completed several support and resistance lines, one student in the back of the room made an observation not unlike that of others before him. “There are lines everywhere! How can this be useful? How can we know which one is going to contain price on any given move?”
This was certainly a good question, although I had already provided clues to this prior to leading up to support and resistance. It appeared that most of the other students had already caught on to this as well, as several started to answer the question for me. Thus is the subject we will consider in this article. How do we take advantage of these lines?
There is no “one right approach” or use for support and resistance price lines. Situations and circumstances change from day to day, market to market. However, if you learn the various uses and approaches in analyzing markets using support and resistance lines, in time you will be able to “see” the clues you need to make better market calls.
Although I prefer Fibonacci ratios, let us start with the basics using Gann ratios. They are close enough for government work. For static Gann ratios you only need to divide any given price range by eight. Each division then, or support and resistance line will form at [ intervals. That is, each will be 12.5% of the overall range.
It should become obvious at this time that if you were to divide very small ranges into 8 divisions, you are going to get prices that are just a few ticks away from each other.
Granted, I would consider doing such a thing an exercise in futility. It is ultimately better to apply such divisions on price ranges that offer greater distance between each division.
W. D. Gann liked to make reference to the distance between these divisions. He once said “When the range between the 50% point (4 eighths) and the 62.5% point (5 eighths) is 8 to 12 cents or more, and the commodity crosses the 50% point, it will go to the 62.5% point and meet resistance.” We will cover what he is saying shortly. I want to point out how important some spacing is to have between divisions. By using well-defined ranges that are not too small to divide, you minimize the problem of having too many lines. Yet, this alone is not enough.
There usually will be many ranges in a price chart for which the analyst can apply Gann ratios to. And obviously, if you do enough ranges, you are going to have horizontal lines marking the divisions all over the place. We now must consider other ways of making sense of this webbing.
The first thing you will want to do is to note those lines that tend to overlap each other. Such overlapping is called “confluence.” These are support and resistance values that you want to watch closely.
Next, you want to pay more attention to those support and resistance levels that were produced by the more recently formed range. As a matter of fact, it should be the range that price is currently retracing.
For example, if price were currently moving down from a top, then the most recent range would be from that top down to the last bottom. If current price is already lower than the last bottom, then price has already exceeded 100% of the recent range and you will need to use the next range prior. Defining which tops and bottoms constitute a range is a completely different subject altogether, as you need to get into “scope” and “waves.” I will leave that for another time.
Now what did Gann mean in the quote mentioned earlier? Say for example that you have divided a decent price range by eight. How might you use this as is? Gann was saying that if price were to move to the one-half point (50%) and eventually break beyond it, that price would likely continue to the next [ division.
The best way to visualize the effect support or resistance has on market prices is to consider an office building with many floors. Now, if a large metal ball were to be hurled down from the sky towards the top of this building, it is likely to break below the roof and several floors before finally resting on one of the floors.
How many floors it breaks through depends on a few things, such as the thrust, mass and strength of the floors. Was the floor that the ball finally rests on stronger than the previous floors? Possibly, but that alone was not what stopped the ball from falling further. The floors above had “slowed” down the momentum of the falling ball to the point that the final floor was able to stop the failing. This is much like how support price zones work in the marketplace.
When price breaks below a support price level, it usually will move to the next support level and test it. Knowing this is very important to an analyst. If it still fails to hold price, it will usually drop to the price support zone below.
At times, I have provided the public with two or three of these support and resistance price zones. It soon became evident that many traders are not aware of their proper use based on a few comments it would generate.
A recent example would be the T-Bond market. Here I provided a support price of 89:03, then 88:19 and finally 87:08. For the uninformed (or uninitiated), this might have resulted in comments that no forecast is really being made. The problem here is that some want everything handed to them on a silver platter without any work at all on their part. Sorry, but I am not in the business of babysitting (except my little 4-year old daughter.) Educate I will do though.
Bond prices were dropping at the time, and went as low as 89:06 and bottomed out, followed by a rally. The bottom it made at this time was only 3-ticks off our 89:03 support zone. That is quite acceptable and close enough. At some time in the future it will be taken out in favor of even lower prices. The previous support zones may or may not apply at that future time. All depends of course on the most recent ranges soon to form. Now, if price were to drop below that first price zone, we would then have looked to the next one. This certainly helps if we were looking for a place to buy.
For example, if we had a support value of 250 in Wheat, and the next one at 241, and price were to move down to 246, would you want to buy at 245, 244 or 243? With price likely to drop to around 241, you would expect price to drop a few cents more rather than try for it at mid-distance. As you get better at solving for support and resistance, you will soon get familiar at how close certain markets get to pre-calculated price levels. This is yet another way to isolate the zones of importance.
My favorite use of price zones is in conjunction with “time” zones. For example, if price happens to be moving up from a newly formed bottom (a rally) in a down trending market, I am going to want to take the most recent price range and get many price zones. It is expected that a rally top will form at one of these. Now say that price reaches the 37.5% resistance price zone without breaking above it and closes. Without using “time,” I could plan to short with a stop-loss a few ticks above this zone. If wrong and price goes to the 50% or 62.5% zones, I will be stopped out and can try again later.
However, what if I am using “time” and it is not for at least a couple of days? Then the probability would be high that price will continue up to one of the higher levels to form that rally top within the expected “time” zone. Here, it does not matter how many lines are on the charts, does it? It only matters which ones price is around come the expected “time” day. Using “time” along with “price” increases your odds of discovering where a top or bottom will form.
We have discussed the importance of using ranges of decent size for calculating static price zones (support and resistance). We have discussed how the overlapping of these zones add extra credibility to a price zone that price will be resisted at that area if and when it gets there.
We have also discussed how the mid-price areas between these price zones would be better left alone when deciding where to enter, expecting that price will reach closer to your pre-calculated areas rather than in mid-flight. Finally, we have discussed how “time” can greatly increase your odds in discovering which price is likely to produce the price reversal.
Gann once said about the 50% division of the highest price in a market it’s the “balancing point because it divides the range of fluctuation into two equal parts.” He stated that it would act as resistance to rising price and support to falling price. Furthermore, he said “The wider the range and the longer the time period, the more important is this half-way point when it is reached.” You can make a fortune by following this one rule alone. A careful study and review of past movements in any Commodity will prove to you beyond doubt that this rule works. . .”
Yes, you will have to prove that to yourself. Also, take to heart the words “careful study and review.” There is so much to learn in price analysis. But if you have an open mind, a real desire to learn, and put in the time to do so, many doors will be opened to you.