At the core of market trading is momentum which is at its greatest when old highs and lows are broken. MoneyAMs Mike Boydell explains how to take advantage of it

One of Isaac Newtons laws of motion was that the most likely thing for a body of matter to do is to keep on doing whatever it is that it is already doing. If it is stationary, the most likely course of action is that it will continue to be stationary. If it is accelerating downwards, the most likely thing that it is going to do is continue to keep accelerating downwards.

In fact, if we think about it, the laziness of trend-following is something we accept in nearly every aspect of our lives every day. For example, the most likely thing for a successful business creator to do is to keep on creating businesses; the most likely thing to happen on a rainy day is for it to keep on raining; the most likely thing for a prolific goal scorer to keep on doing is to score yet more goals; the most likely thing for a bird flying south to do is to keep on flying south.

Why? Because change takes a huge amount of effort and power.

On shares and on most tradable instruments, this is still very true. For a rising stock to suddenly change direction, there will need to be a sudden influx of sellers or a big change in sentiment. Likewise, for a falling share to suddenly increase in price, a large influx of buyers or a sudden change in sentiment will be needed.

In the case of shares, momentum is also often at its greatest when old highs and lows are being broken. The reason the momentum is so strong at these points is that contrarian traders use the logic which says that old high and low points are safe places at which to sell (rising market) or buy (falling market).

They believe that if the market has failed to penetrate these levels before, they will fail again. Sometimes they do and those can be good places to trade. This is normally because there is a large commercial or institutional seller who does not fine-tune his order sitting in the market. He will just have a very large sale to complete and generally just lets it stay at one level all day or longer until he is all sold out. This is why the market will fall back every time it hits this point.

But if these points do break, all sorts of people have to run for cover at the same time and place. By breaking the point at which they were trading against the trend, the market has proved their philosophy wrong and indicated that the large seller, who they were piggybacking off, is no longer there to protect them. Being good, disciplined traders, they will cut their losses (in theory).

So, at these points, there are very few people to take the other side of these trades. There is a wall of movement in one direction.

An analogy would be when a rush hour train comes into Waterloo station from the suburbs. Early in the morning, there are going to be a lot of people going to work in the big city and not many going the burbs. If we were to go against the tide of workers, we would have to expand a great deal of energy to make little progress. If, on the other hand, we go with the majority, we are carried along nicely and with little effort go a long way.

We should therefore be able to derive quite a lot of comfort from the fact that if we are long of a rising market or short of a falling one, probability is on our side.

What we want is trades that have a definable pattern and what we want to avoid is the sideways-moving trade. Having money tied up in a share going nowhere costs money in both the long and short term.

As examples, we will use a simple line chart, although a line chart only shows the closing price of each stock and not actually what happened during each day. To get the full impact of the 1-2-3 method, bar charts will give you true intraday support and resistance points.

Back to basics support and resistance

Support and resistance levels form the foundation of most chart patterns, and visually are the most identifiable points on a chart.

Support: A support level is the price at which buyers (demand) are expected to enter the market in sufficient numbers to take control from sellers and prevent the price from declining further.

The market has a memory. When price falls to a new low and then rallies, buyers who missed out on the first trough will be inclined to buy if the price returns to that level. Afraid of missing out for a second time, they may enter the market in sufficient numbers to take control from sellers. The result is a rally, reinforcing perceptions that price is unlikely to fall further and creating a support level.

The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

Support does not always hold and a break below signals that the bears have won out over the bulls a new willingness to sell and/or a lack of incentive to buy. Support breaks and new lows signal that sellers have reduced their expectations and are willing to sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level.

Resistance: A resistance level is the price level at which sellers are expected to enter the market in sufficient numbers to take control from buyers. When a price makes a new high and then retreats, sellers who missed the previous peak will be inclined to sell when the price returns to that level. Afraid of missing out a second time, they may enter the market in numbers sufficient to overwhelm buyers. The resulting correction will reinforce market perceptions that price is unlikely to move higher and establish a resistance level.

The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

Resistance does not always hold and a break above resistance signals that the bulls have won out over the bears: a new willingness to buy and/or a lack of incentive to sell. Resistance breaks and new highs indicate buyers have increased their expectations and are willing to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level.

Using the basis that a break above resistance or a fall below support could mean a major change in direction/sentiment, we can then see that a simple pattern emerges.

1-2-3 (A-B-C) Bottom

Anticipates a change in trend from down to up on a break above the No.2 point. No.1 point in an ideal world would be the years low but, if you are a short-term trader, it could be a low made in the past few weeks or even intraday (short-term support). Market breaks up to No.2 and falls back to No.3. The point No.3 should be higher than No.1. Breaking out above point No.2 confirms a change of trend and is the point to look to buy as it means that a potential point of resistance has been met and broken.

As this pattern is recognisable ahead, you can forward-plan this trade. Perhaps place an initial stop loss at either points No.1 or No.3 so, if the stock reverses, it could find support at these points if it fails at No.1 and No.3, it could get bad!

1-2-3 (A-B-C) Top

A complete reversal of the above, one for the bears/shorters. Anticipates a change in trend from up to down on a break below the No.2 point; this provides a signal to short or certainly to close out a long position.

1-2-3 (A-B-C) Top

Markets do not, of course, just move up or down in a straight line and this chart is a typical example. It is quite clear that, right now, its general direction is up, so the only way in which we could have made a profit was to be long of it. The trouble is when do we get in and how do we find when it has stopped going down?

Now, using the probabilities we discussed above, let us look at the chart (p66) in more detail. The answer to these questions is to be found in the points labelled A to O. All the labelled points form either support or resistance and they are tremendously important. They tell us a great deal about the market and its likely future course.

From point A, the market started down, as the weight of selling was greater than the power of buying. It continued down until it came to point B, where temporarily, greater buying power took over. The force of this buying was overpowered by selling again at point C and from here the market continued down again to point D.

When it reached point D, it again rose but fell away from point E to point F. Now, this is the part we are really interested in. Although it fell away from point E, it only fell to point F. Critically, point F was higher than the point that we had identified as a previous significant low point D (short-term support point).

This is absolutely critical and valuable information. At this point (F), the force of buying was so great that for buyers to get as much as they demanded, they had to pay higher prices. No one was willing or able to sell them all they wanted at lower than point F. Previously, at points A and C any buying demand was overcome by the quantity of sellers, so the price continued to fall.

Using Newtons Laws of probability and the critical significance of support and resistance points, we know that something very significant and powerful will be happening to this market if it can absorb and take out all the selling that has previously occurred at point E. We have decided that if the market can rise above point E, it will have displayed significant strength and the probability is that it will carry on up. So, we can consider buying this market after the break of point E has been confirmed. Buying actually at point E could be dangerous as it could form a double top: safer to leave it a day for confirmation. But if we do buy at or around E, we are now long.

Using the momentum philosophy, it indicates that there is a high probability of producing a profit. But we have to accept that, although we believe we are employing a high-probability methodology, we can still be wrong, anything can be wrong. So we need to address this issue and have a method of dealing with it to protect ourselves from any potential losses or at least to ensure that the losses are small.

How do I contain or control any losses, should they occur? The answer must be that if, having proceeded past point E, the market were for some reason to fall back again to at least below point E or certainly below point F, our reasons for getting into the trade will have been invalidated. This is not unusual, otherwise every trade we did would be profitable and we would all be on a beach in the Bahamas. Perhaps we will offer a warning that at point F or below, you should close the trade out and take the small loss before it becomes a big loss.

Working up the chart above, clear buy signals occur as further short-term resistance is broken opposite points G, I and K. These are potential new entry points or perhaps somewhere to pyramid a trade.

The market towards the end of the chart falls back from point M to N where it finds support and breaks up again to O. At O, it fails on resistance and falls back considerably. However, as it falls it provides a short signal (or sell if you are long) as it breaks opposite N.

The few real stock examples right will show better how it all works in reality.

Mike Boydell is managing director of MoneyAM (www.moneyam.com). He is also a director of Global Markets Training (www.glomtc.com) and Traderpc. He has been an active private trader in the UK for 13 years.