Playing the Spread
Most investors understand the terms "resistance level"
and "support level". The "resistance level" is
set when a stock that is moving higher "runs out of gas"
as selling starts to outweigh buying. The "support level"
is where buying and selling on a falling stock basically
even out. What is of interest is what happens "between"
Have you ever heard the term "rolling" stock or
"channeling" stock? This is a stock that "rolls"
between a support level and a resistance level, and often
this pattern repeats many times.
For instance, suppose we have the XYZ stock, and it has
support at about 50 dollars. As it travels along that
support level, eventually buying starts to overcome selling
and it starts moving back up. Now suppose it runs up to 58
and starts to fall back. We now have support at 50 and
resistance at 58. Traders will study that chart, and some
interesting things will start to happen. First, as the stock
weakens it attracts short sellers who make money if the
stock falls. Chart readers see that the stock has support at
50, but it hit resistance at 58 and started falling. They
feel they can short it back to around that 50-dollar level,
and they actually help drive it down. This is why bounces
off resistance levels are often so strong.
As the stock falls toward the support level, those short
sellers will start to "cover their shorts," and they
do that by buying the stock (a short sale uses "borrowed"
stock that must be replaced). So as the stock nears its
normal support level, more and more buying comes from
traders covering shorts, along with people who initiate
positions simply because it is at support. That often pops
the stock off the support level. Once that motion of setting
a resistance level and falling back to support is found,
thousands of traders can zero in on the stock, creating a
rolling stock. As the stock starts back up, all the short
sellers become buyers and XYZ gains momentum. As it nears
the resistance level of 58, the shorters start selling again
and down it goes.
This pattern of running up, banging against resistance
and falling back to support can repeat multiple times. As
the pattern repeats, though, an interesting thing occurs.
Usually we see the support level creep a bit higher each
time and the resistance level come down a bit each time.
Why? Suppose you bought XYZ on its first run to 58 dollars,
and then it dropped. What do you suppose you would do as it
nears 58 again? Sell. That is why there is a resistance
level - everyone trapped at the high wants to sell as soon
as the price gets somewhere close. So we see selling begin
at the 57 level. Eventually that becomes the resistance, and
soon it is 56. On the other side, we see the support move a
bit higher. That is because the short sellers do not want to
cover right at support (it may not fall that far), and they
buy just ahead of it, say at 51. Soon it will be 52, etc.
But you may have had the chance to buy XYZ at 51 and sell it
at 56 several times. Likewise, you may have had the
opportunity to short it at 57 and cover it at 51 several
times. This is a rolling stock.
If volume is strong enough, some major things can and
often do happen. We may see the pattern "cone down"
or, in other words, the distance between support and
resistance becomes smaller and smaller. This is commonly
called a "pennant formation" or a triangle. Once the
tightening of the pattern gets so small on the "cone end"
that there is no room left (say XYZ now has support at 54
dollars and resistance at 56), we are close to a big move.
The stock may break out and run to the upside, or it may
break down and fall. The break--in either direction--is
usually a very strong one.
Other times the pattern does not cone down much, but the
forces are still in effect for a breakdown or a breakout.
For instance, say XYZ has been rolling between 50 and 58
dollars for a couple of cycles before topping out at 57 and
starting to fall. Naturally, the short sellers are hitting
it pretty hard now, which is driving it down even faster.
But suppose XYZ announces some great news like a stock
split, and a tremendous amount of new buyers appear. Guess
what? XYZ could be looking at a short squeeze. That is when
an unanticipated event drives up a stock that has a bunch of
short sales in it, and all those short sellers have to buy
XYZ at the higher price just to get out of the trade. For
instance, say XYZ has fallen to 56 when it announces that
Microsoft is investing $100 million in the company and
everyone jumps into the stock. In no time, XYZ has broken
through its old resistance at 58 and is heading higher on
the momentum. The short sellers must buy, too, creating even
more upside pressure. This is a classic breakout.
As you can see, locating the resistance level and the
support level will allow you to "play the spread"
between them. When the stock approaches either level, you
will know that something is about to happen.
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