April 14th, 2011

Support and Resistance: A Dynamic View

I’m always somewhat skeptical of the certainty with which some technical analysts, especially those less experienced, proclaim that a stock or index is about to cross above or below a support or resistance trendline. They insert trendlines on their charts as if they were constructing magical concrete permanent barriers. Rather, those trendlines identify nothing more than the analyst’s visual representation of places where changes in momentum between buyers and sellers (a pivot) took place in the past and, therefore, where control might change again in the future.

Trendlines, however, are merely aids for describing possible future action; they never guarantee a specific outcome. The area’s of future likely pivots are highly subjective so technical analysts should never be so fixated on trendlines they may have drawn on a graph that they’re unable to be to see different configuration as time goes on and new information is presented.

This is never more true than during consolidation period like the one most stocks and, in turn, the market as a whole is now working its way through. QSFT (Quest Software), is a good example (click on images to enlarge):

The market’s bull run since last August propelled QSFT to a 50% rise after breaking out of a horizontal trading pattern that coincided with the market’s own year-long trading range that began in October 2009. The S&P 500 is now caught in a 1255-1345 trading range as at it consolidates the 25% run higher since last August. QSFT likewise stopped moving higher and for the first quarter made what to some likes like a classical reversal pattern:

By March 15, QSFT you could see a precise classical head-and-shoulder reversal pattern. If a technical analyst looked at the chart in isolation, without the benefit of a broader market perspective, they would either sell their holdings or sell the stock short. However, note that 1) there’s a divergence between the longer-term OBV trend (no lower than it was when the stock was 32% lower in July) and 2) the fact that the overall market hasn’t signaled a trend reversal to bearish.

As time passed, a totally different chart pattern emerges, one that’s more in sync with a more constructive view of the market. If the market’s current consolidation is considered merely as a brief respite in a traditional “mid-term election cycle” bull market then QSFT, with the benefit of more recent data, should also still considered to be in consolidation. As of yesterday’s close and if new trendlines are drawn, that consolidation might be best characterized as a wedge pattern:

The OBV trend is still favorable, and the neckline of the head-and-shoulder pattern hasn’t yet been broken. If the stock (and the market) is able to avoid further deterioration in the short-run and then move higher as this consolidation phase winds down, then the QSFT consolidation would ultimately turn out to be a wedge pattern.

Rather than being committed to and making trading decisions based on the head-and-shoulder originally conceived, technical analysts must be willing to incorporate new information, especially a view of the broader market’s longer-term direction.

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