Share price movement is non-random and usually moves in a particular direction over a period of time. This observation that is commonly referred to as trend. Within this period, we are reasonably confident that the share will continue to move in this direction. Hence with the ability to identify the trend comes the ability to trade the trend and make buy/sell decision based on our observation. In this article, we will show you how to construct support and resistance lines, which is one of the most basic technical analysis tool but yet among the most powerful and useful for trend identification.

First of all, it is important to note that when a share moves in a trend, it does not move in a straight line but in a zigzag fashion. See diagram below for a hypothetical illustration.

Drawing support and resistance lines

With these zigzags, we are now ready to draw the support and resistance lines that define the trend. The rules are very simple.

1. Support line is drawn by linking up the major low points.
2. Resistance is drawn by linking up the major high points.

See diagram below for a hypothetical illustration. Do also note, the support lines are parallel to the resistance lines, which is known as a parallel channel.

Why are support and resistance important?

Remember that technical analysis is a study of probability. Support and resistance are important because using them we are able to make some probabilistic predictions.

1. If the share price has fallen near to the support line, then the probability of rising is higher than falling. If the share price has risen near to the resistance line, then the probability of falling is higher than rising.
   
   
2. As long as the trend remains intact, it has a high probability of continuing its movement in the same trend direction.
   
   
3. If the share price falls below the support line, then there is a high probability that the existing trend is broken such that the share price will move in a new down trend.
   
   
4. If the share price rises above the resistance line, then there is a high probability that the existing trend is broken such that the share price will move in a new up trend.
   
   

Knowledge of the probabilistic induction allows us to construct 2 effective trading strategies.

Trading strategy I: Trade the existing trend

The first strategy is to trade the existing trend and to buy near support and sell near resistance. The entry, exit and cut loss point are completely identified, thereby defining a complete system that we can follow as the share price unfolds.

Below is an example of how to execute this strategy on the long side.

A) You made the first purchase on Nov 2003 at a price of $1.72 with a cut loss point of $1.63, which was based on 5% below purchase price.

B) This position was sold off on Feb 2004 at $2.20, realizing a 27.90% gain of $0.48 over 3 months.

C) You made the second purchase on May 2004 at a price of $2.15 with a cut loss point of $2.04, which was based on 5% below purchase price. After this purchase, the support was broken indicating a trend change. You decided to hang on to the position as the new trend might be sideway or a less steep uptrend, and the price did not reach your cut loss point.

D) You confirmed later that the new trend was indeed an up trend with a less steep gradient. Another buy opportunity presented itself on August 2004 at $2.20. To avoid over-exposure, you decided to give it a pass as you had yet to sell off your previous holdings.

E) Eventually, you seized the opportunity to sell off on Feb 2005 at $2.70, realizing a 25.58% gain of $0.55 over 9 months.

Trading strategy II: Trade trend breakout

The second strategy is to trade trend breakouts. However, trading break out is more difficult as the exit point is not identified and usage of other technical indicators and tools are required. Hence this strategy is not recommended unless you have other methods to determine the exit point.

Parallel channel is the friend of novice chartists

Drawing support and resistance lines sounds easy. However, there is one major issue: the usefulness of trendlines is highly dependent on the chartist's ability to construct them accurately. Or in simpler words, there are often more than one way to draw a trendline. See below for an example.

As you can see, both support lines fulfilled the requirement of linking up low points of the share price. So which one is the 'correct' one? There is no simple answer to this question. How a trendline should be drawn is highly dependent on the chartist's interpretation of the situation. The ability to draw trendlines accurately will come naturally as the chartist becomes more skilled and experienced.

That's why we choose to begin this first article on trendline studies with parallel channel. Parallel channel is the friend of novice chartists because the probability of constructing wrong support and wrong resistance that are parallel to each other is much lower than that of constructing a single wrong trendline.

It is hence a good exercise to identify and draw as many parallel channels on as many shares as possible. If you are new to technical analysis, I am sure that you will start to appreciate the art of technical analysis after going through this exercise. Have fun.