We talk a lot about support and resistance areas in the market but what we would do if the market breaks through these important areas. Support and resistance levels are psychologically important areas in the market that act as a magnet as markets get close to them and are typically difficult for markets to break through. As a market goes up or down it usually hits an area where it stalls before breaking through and continuing the trend. These areas become support on the downside and resistance on the upside. For example, as I write this the S&P 500 had a major decline yesterday and closed at 1930. If you look at a chart of the S&P you can clearly see a number of times the market tried to break through 1919 and failed. Therefore, 1919 becomes the next big support level which you would expect the market to test because it is so close and you would expect some problems breaking through it. Support and resistance can also tell you other things about the market. Murray Ruggiero, our chief systems analyst predicted in early 2008 that the Dow Jones Industrial Average would ultimately go to 7700 (he was off by a bit as it hit 6600 but still a great call). This wasn’t based on a crystal ball it was based on how markets work around support and resistance areas. Typically when a market hits a low it tests and retests that level before rallying. In 2002 the Dow hit 7700 and never looked back, meaning it was likely that at some point we would retest that level which we did. So the main benefit of looking at support and resistance levels is to get a feel for what markets are likely to do and to help explain market movements.
Unless you are a day trader support and resistance levels don’t help much. We will use them when we are already trading to decide where to place our limit orders but we won’t get out of a market just because it breaks through support or get in because it breaks through resistance. Down moves in any bull market are normal and healthy but typically they just end up being noise and are retraced back to the upside. Down moves that are just noise are great buying opportunities, panic sellers usually end up regretting it. True trend changes however are significant as they can result in double digit losses that are hard to come back from. Our goal when the market goes down is to try to judge whether the move is just noise or a true change in trend. We will never be 100% right, sometimes we will get out of a market and it will snap back up, but if we put the odds in our favor we can do everything possible to avoid the large long term loss.
The last true trend change I remember was August 2011, that was the month that the wheels almost came off the global economy. Central banks where able to act and stem disaster but it was a period where it made sense to exit the market as the risk of being invested outweighed the rewards. The last time we got out of the market was February of this year as the down move we had in January looked like a change of trend but at least in the short term it turned out to be noise and we got back in.