How to Play a Break of Support (by Leaf_West)

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This blog post is more of a teaching/educational post, which is what my site "Trading with Leaf-West" is really all about.  Therefore, no wise cracks for experienced traders who this post is not meant for … Cheers.

This post came about from a question by a reader (Hal) … I encourage readers to make comments and ask questions as I am happy to try and help readers with their trading.

Anyways, Hal had a question about how to play the potential break below the $134.00 level in the SPY today.  I will hopefully answer that question and then add some other things I have learned/noted over the years regarding horizontal support breaks.

Before I go further, I wanted to state that I think all traders should be looking pre-market at the past several days to determine obvious support prices for what ever instruments they trade or indexes they plan to trade/follow.  With out a question, these levels will give you increased confidence and edge in your trading.

I actually draw horizontal lines right on my charts for stocks/etf's I trade and I always have them for the SPY ETF.

$134.00 Support:

When price bounced right off of the $134 level this morning, it triggered me to start looking at whether or not this could be meaningful support.  I started looking at retracements and extensions and posted the following chart … (please note that this is my blog post chart space which has no support/resistance lines drawn on … I don't look at this chart, I only use it to draw for my blogs).

SPY_May11, 2011_3min_ABC

Two things struck me … first since the lengths fit more to an ABC corrective move (C= exactly 1.382 x A), I gave less odds that this was a 3rd wave and therefore I thought that a 5th wave lower was not necessarily going to happen today.  As background, I like to look at large downdrafts and updrafts to see if they "fit" into a 3rd wave scenario and therefore I can trade a 4th and 5th wave with more confidence/size/edge.

Secondly, TICKs put in a huge/large negative TICK extreme at -1704 on this push to $134.00, which made me think that this low could be near the final low of the day.

Now, very rarely will you get a "V" shaped recovery after a large push lower like the one we had this morning.  You will almost always get a retest as a minimum if this was indeed going to be a significant low.  In essence, traders will not be willing buyers in real size until the market proves to them that the low will hold.

Arc Trends lower (i.e., inverse parabolic moves) can and often do give you a "V" shaped bounce that doesn't necessarily come back to test the bottom.

Anyways, with the possibly meaningful bottom put in at 12:15pm, I was looking to the typical 1:30pm and 2:30pm pivotal time slots as the most likely areas where this market would test/fail a push below $134.00.  I posted the following chart as part of the same post just after 1pm:

SPY_May11, 2011_3min_ABC_02

As you can see, I was looking for some consolidation between $134.00 and $134.50 until a final move lower or higher starting at around 2:30pm.

Now I am sure that I was the only trader in the world thinking this right? …. WRONG!!  Every trader in the world was waiting to see what was going to happen at $134 (including me and Hal).  You have to think about what the average trader is going to do so you can adapt and give yourself some edge.

I will talk about what I like to do for breaks between various times of the day later, but suffice to say for a potential break lower in this case this afternoon, I never short the initial break.  I let the break happen and monitor with the intent to short on any weak bounce higher that fails to recover back above the break line.  I will draw hypothetical examples for what could have happened today.

Break_01

Break_02

Break_03

Now obviously the scenarios are generalizations in how they look, but you would be surprised how actual breaks fit into these patterns.

Here is what happened at the first retest at about 1:30pm …

Break_04

Now I was not convinced enough to try this failure at 1:30pm … my thoughts were that the real test was going to come near 2:30pm so I ignored this move in the SPY.

Here is what happened between the time above and the 2:30pm test …

Break_05

The second test at 2:30pm ish again failed relatively quickly, giving prepared traders confidence to take this failure and get long.  The 2:36pm candle was a large bullish candle that broke above the 20EMA and bounced right into the 50EMA (blue line).

I tweeted that I was going to buy the SPY when it pulled back using the Stochastic indicator on my 1-min chart.  I actually went long at the 20EMA at $134.17.  I sold 1/2 on the move to $134.40 and planned to take the remainder off at $134.53 in front of a pivot price ($134.55).  I raised my stop to $134.30 and was stopped out a while later.

I didn't max out the profit potential of that trade but I did manage risk very well I thought.  Remember, I am a Momma's Boy so I did ok.

Here is the chart for the remainder of the day …

Break_06

Note how price is still inside that horizontal triangle … expansion follows contraction.  Expect that to happen tomorrow.

Time Zone Break-Downs/Highers:

I look to the time of day to give me guidance when looking at horizontal line breaks.  I have found that you can categorize breaks into the following time zones:

  1. 1st Hour (till 10:30am pivot time)
  2. 10:30am – 11:30am ish
  3. Lunch Time Period (11:30am – 1:30pm ish)
  4. Afternoon Session (1:30pm  – 3:15pm ish)

During the First Hour, I will only fade tests of horizontal break downs.  I will almost never go with a break of a support price during this time.  Depending on other factors, I may initiate a small position on a break higher, but never on a break lower.  Price has a tendency to reverse/pivot during the first hour before starting its morning trend.

For breaks between 10:30am and Lunch time, I will initiate a starter position on the break of the actual break down price.

During lunch time I will almost always fade a break down/out.

After lunch-time and before crazy time at 3:30pm, I will trade as per all the examples noted above in the charts.

Graphically, my rules are as follows …

Break_07

I hope that helps Hal and the rest of the blog's readers ….

Cheers … Leaf_West