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An Easy Way to Determine Support and Resistance

If you read the stock recommendation on the newspaper or internet media, there are often words like this: ‘We predict that Jakarta Composite Index (JCI) today will move in range 3,087 – 3,217’. Well, you must be understand that the smallest number, which is 3,087, is called as support point, while the biggest number, which is 3,127, is called as resistance number. So, how does a security analyst define the support and resistance points? It turns out to be an easy way. You can do it yourself, even in just seconds.

Support and resistance is the term to call the ‘lower limit’ and ‘upper limit’. So, if a stock continues to fall until it reaches or exceeds the support line, then technically, that stock has the support to strengthen back. On the contrary, if a stock continues to rise until it reaches or exceeds the resistance line, then the stock has resistance to weaken back.

In technical analysis, the lower or upper limit is actually just a psychological limit, and not a strict limit that cannot be exceeded at all. So if it’s said that, ‘JCI will move around 3,087 – 3,127’, then it doesn’t mean that JCI will not fall lower than 3,087, or rise higher than 3,127. It’s just that, as already explained above, if JCI had fell lower than 3,087, then on the next periods, JCI is likely to strengthen. Likewise if JCI had rose higher than 3,127, the on the next periods, JCI is likely to weaken; to be back into its position between its support and resistance lines.

There are some analysis methods to determine the lower and upper limits. Some of them are by looking at the highest and lowest point in certain period, using Fibonacci series, or using pivot method. All those methods have their own advantages and disadvantages, so it doesn’t matter if you use any of them.

But the problem is, those methods also have many formula and it’s pretty complicated to calculate them, so they cannot be done in a short time, particularly in just seconds. So, how? There is one other method that I normally use, which is called as Bollinger Bands (let’s abbreviate it into BB). I’m sure that some of you have used to this method to determine the support and resistance, due to its simplicity and accuracy it offered. But let’s hope this article will be useful for those who don’t know yet.

What is Bollinger Bands? BB is actually a development of the simple moving average method or SMA (to study SMA, read here). This method was found by John Bollinger in 1980s. To put it simply, here’s how:

The midline of BB: is the SMA itself, with certain period of time. Let’s say, 20 days.
The lower line of BB that becomes the support: SMA – certain formula.
The upper line of BB that becomes the resistance: SMA + certain formula.

What is meant by ‘certain formula’ above is certain deviation period (usually 2 periods) times its deviation standard. The deviation standard is a statistic formula to measure how big a change or variable of the data in the future. Because we are not studying the science of statistics here, then we will not discuss it any further.

BB is very powerful to determine the support and resistance, which means that everytime a stock moves down and exceeds the support or moves up and exceeds the resistance, then the stock will be ‘forced’ to be back into its previous position. Here’s the example of the use of BB with period of SMA 20 days, which is taken from JCI’s movement in the last six months (since 25 February until 7 August 2010). Click image to enlarge.

There are four lines on the graphic. The blue line is JCI’s movement, the upper red line is resistance line, the lower red line is the support line, and the green line is the SMA line (you can also call it as midline). If you note the graphic overall, then you’ll see that JCI is very rarely to move above the resistance line, or below the support line. Even if it happens (e.g. on circle no. 1), then JCI will then move down and back into the position between the upper and lower limits.

Note the circle no. 2. That’s the JCI’s position on 7 May 2010, or a week after correction in May started. At that time, JCI was on the position of 2,739, which fall drastically from its position of 2,971 on 30 April. However, that position was still far below the support line, so in the next day, JCI directly rose back, although at that time was still in May (so the increase can be said due to the technical factor improvement, we could say it ‘technical rebound’).

Some days later, which was on 19 May, JCI fell back into the postion below the support line. But because its support line was also in declining condition, then JCI wasn’t necessarily strengthen back. Then on 25 May (circle no. 3), the support line stopped moving down, and JCI’s position at that time was 2,541, which was far below the support line. The next thing is predictable: correction in May has finished, and on the next trading day, which was on 26 May, JCI directly soar into position of 2,697, and continued to rise until its current position.

The IDX is one of the most optimistic stock exchanges in the world. That’s why, in normal condition, JCI’s movement almost always came near its upper limit line. JCI is even rarely in the position below the midline, where everytime JCI comes near to the midline, then the next, it will strengthen back (note the circle no. 4, 5, and 6). Therefore, you are now capable to predict the JCI’s movement without having to pay attention to the review on the newspaper or internet. You can do it yourself with quite good accuracy prediction, by using BB only.

That was the use of BB to see JCI’s support and resistance. However, what the benefit it has in terms to predict the price stock movement?

So, here’s how (this is the point of this article). I used to use BB to observe the declining stocks, to see whether the decline is already maximal or not. Because if certain stock has fallen maximally, then logically, the stock will definitely rise back, right? So that it can be an opportunity to buy on weakness.

Have you remembered sometimes ago when Bumi Resources (BUMI) suddenly fell drastically? In mid June until mid August, BUMI was stable on the position of 1,600 – 1,700. But on 12 August, BUMI suddenly fell into position of 1,580, and continued to fall until it reached position of 1,670 in just two trading days. What caused it to become suddenly increased? Maybe this following image can explain it. (click to enlarge).

The above image is the graphic movement of BUMI’s stocks in the last month (30 July – 27 August 2010). Note the position of BUMI on 19 August, which was on 1,290 (circle no. 2), has already far below the lower limit (and the declining line has also already very steep). Consequently, only in just two next trading days, BUMI directly back into position of 1,670. It means gain of almost 30% in just two days!

Actually, BUMI has already attracted the attention on 12 August, when its price was at 1,580 (circle no. 1), because its position at that time has exceeded below the support line. But due to some considerations like: 1. The gap hasn’t too far, 2. In some previous periods, BUMI was almost in the position near the support line, 3. The declining of BUMI was caused by the declining of Bakrie Stocks overall, and 4. The coal sector itself was on the bad condition, after some coal companies recorded decrease in performance on first half 2010, then at that time, BUMI wasn’t good enough to buy although its technical suggested otherwise. BUMI has just got its buy recommended status after it continued to fall and reached position of 1,290, which has already below the support line.

You can check for the other stocks, which mostly have the same tendency (strengthen if it has already dropped from the support line), particularly if the trading volume is liquid. The difference is usually on the percentage gap of the strengthening: There’s one that soar like BUMI, there’s also one that only increase 1 or 2%.

Just like moving average, I also used to use BB only as the tool in determining whether a certain stock will rise or not, to reinforce the conclusion (by fundamental analysis) that has been made before. But for those speculators who like to hunt for the sag stocks, BB can be a very useful tool.

Then how do we see the Bollinger Bands line?

As I’ve already mentioned above, you can see it just in seconds, because Yahoo Finance provides you with the facility to calculate it automatically. When you are seeing a graphic movement of a certain stock in Yahoo Finance, click the ‘Technical Indicators’ tab above the graphic, and then click ‘Bollinger Bonds’. Let the period and its deviation on the default position (20 and 2), and then click ‘Draw’, and the red (or another color) line will appear. If you want to see it for the short-term, then the period can be changed with smaller number, such as 12, 8 or 5.

In the next week article, we will discuss about tips to purchase stock of IPO. Well, not really a tips, but inputs so that you won’t choose the wrong stocks in the exchange. It’s because in the next months, it looks like IDX will be invaded by lots of newcomer stocks.

Original article was written on August 31st, 2010.

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