Chart Your Way to Profits

When it comes to judging a stock’s potential, there are really just two schools of thought. They’re called fundamental analysis and technical analysis. And while successful traders often use both types of analysis, the most successful traders master one or the other.

In general, fundamental analysts concern themselves with a company itself. They dig into financial statements and balance sheets. They calculate assets vs. liabilities, sales vs. profits — all the nitty-gritty details to find out what a company is really worth.

Fundamental analysis can be a great way to find stocks for your portfolio that you plan on holding for a long time. But just because a company looks great on paper doesn’t mean the stock market will agree. In the short term, anything can happen. And that’s where technical analysis can help.

Technical analysts rarely worry about companies themselves. They’re more concerned with the company’s stock price. Using charts or other systems, a technical analyst tries to decide where a stock price is going next.

A solid technical analysis system is a great way to take advantage of short-term stock moves. In fact, my proprietary charting system is one of the reasons for Options Hotline’s incredible success. I look for stocks on the verge of big moves up or down. Then I choose the best options to take advantage of the move.

As you may know, I’m also a big advocate of having a firm trading strategy in mind. To help guide that strategy, I also calculate to very important numbers — support and resistance.

These two numbers are the bread and butter of technical analysts. Each one tends to calculate support and resistance in different ways. So it’s not really important to tell you how I calculate them. It’s just important to know what the terms mean.

The technical answer is, support is an area of expected institutional buying. Resistance represents expected professional selling.

Simply put, support represents the expected “floor” of a stock. That is, the lowest price you can expect it to go. That’s because when the price falls to this price, institutions and investors tend to step in, buying up the stock. That buying “supports” the stock price.

Think of it this way. Suppose a fictional company, Widget Co., is trading for $53. And let’s say that brokerage houses have a lot of standing orders from their clients to buy Widget Co. at $50.

In other words, these orders will not trigger as long as Widget Co. is selling for more than $50. But if the stock falls to $50, the brokers start executing the limit orders. All of a sudden, there is a flood of buyers for the stock. The demand keeps the price up.

Of course, support is not foolproof. In fact, stocks can and often do break through their support lines. It means that more people are selling the stock than are buying… so the bears are in control.

When a stock breaks through resistance, on the other hand, it’s a bullish sign. Resistance can be considered a stock’s ceiling. It is the price a stock is expected to have trouble breaking through.

Just like with support, resistance is controlled by institutional investors. Except this time, it is the price at which they can be expected to sell the stock.

For example, assume Widget Co. stock is at $53. But instead of falling, the stock rises. And keeps rising.

In this example, a lot of people will want to take profits if the stock rises $10. So they put in limit orders…and if the stock hits $63, the selling begins. The shares flood the market, driving the stock price down.

Of course, resistance isn’t absolute, either. And if there are more buyers than sellers, the stock will break through resistance. It’s a good sign the stock is on a bull run.

Knowing a stock’s support and resistance can help you decide what to do with your options. That’s because an option’s price follows a stock price. So knowing the “floor” and the “ceiling” can help you determine your trading strategy.

Remember, if a stock breaks through support, it is falling — and the bears are in charge of a stock price. If you have a call option, it can be very bad news for you. You may want to consider selling the option in case the stock goes even lower.

Of course, a lower stock price is what you want to see if you have a put on it. So if the stock breaks through resistance, it should mean profits for you. You really have two options now. You can sell the option, locking in your profits. Or you can ride the stock down, squeezing more profits out of your option on the way.

Just be careful, because the stock can turn around without warning. If you hold on, monitor your position carefully and use proper trading discipline to sell at the best price.

(As you can probably guess, the opposite thinking applies to resistance. If you own a put and a stock breaks through resistance — meaning it’s heading higher — consider selling the put. If you own a call, use your money management system to decide whether to take profits or hang on for more.)

Remember, if you want to make a lot of money in options, it is essential to buy and sell at the right price. Support and resistance are two tools to help you find that right price. Use them correctly — as part of your total money management system — and you should quickly increase your profits.

Steve Sarnoff

May 14, 2007

The Daily Reckoning