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There are times when the market hands an opportunity to traders who use chart analysis. This is one of those times, when markets develop consistent patterns of behavior that can be used to set a profit target and a stop loss, creating a high-probability trading situation.
The common and dominant pattern in today's market is the trading band, created by a well-defined support level and a well-defined resistance level. Each of these levels requires at least three touch, or anchor points. Our preference is to use the close on a weekly chart for positioning these lines, which can often be verified by studying previous support and resistance activity at the level in previous years.
These support and resistance lines also allow for setting good stop loss points to protect trades.
The trading band offers two types of trade. The first is a simple long trade from support to resistance. Of course, they also offer the reverse short trade from resistance to support. It's lazy, high-probability trading offering 10 percent to 25 percent return per trade, at a time when investors complain about low return sideways markets! There's a 23 percent return on the S&P 500 trading band, without using leverage.
The second type of trading band trade is a measured move. Eventually the market breaks out of the trading or consolidation band. How high will it move? The trading band provides the answer.
The depth of the band is measured and this value is projected above the resistance level. For the S&P, this gives an upside target near 2,390. A word of caution, though; if the trading band has been in place for six months, it may take six months to reach the projected target and the up move will not necessarily be smooth and continuous.
The same method is applied to the downside with a drop below the trading band, although down moves tend to be faster, more violent and of much shorter duration.
The key advantage is that traders know when to tighten stops to protect profits and they know when to prepare for a new trade entry.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders, available from www.guppytraders.com.. He is a regular guest on CNBCAsia Squawk Box and a speaker at trading conferences in China, Asia, Australia and Europe.