Playing the Spread

Most investors understand the terms "resistance level" and "support level". The "resistance level" is set when a stock that is moving higher "runs out of gas" as selling starts to outweigh buying. The "support level" is where buying and selling on a falling stock basically even out. What is of interest is what happens "between" the levels.

Have you ever heard the term "rolling" stock or "channeling" stock? This is a stock that "rolls" between a support level and a resistance level, and often this pattern repeats many times.

For instance, suppose we have the XYZ stock, and it has support at about 50 dollars. As it travels along that support level, eventually buying starts to overcome selling and it starts moving back up. Now suppose it runs up to 58 and starts to fall back. We now have support at 50 and resistance at 58. Traders will study that chart, and some interesting things will start to happen. First, as the stock weakens it attracts short sellers who make money if the stock falls. Chart readers see that the stock has support at 50, but it hit resistance at 58 and started falling. They feel they can short it back to around that 50-dollar level, and they actually help drive it down. This is why bounces off resistance levels are often so strong.

As the stock falls toward the support level, those short sellers will start to "cover their shorts," and they do that by buying the stock (a short sale uses "borrowed" stock that must be replaced). So as the stock nears its normal support level, more and more buying comes from traders covering shorts, along with people who initiate positions simply because it is at support. That often pops the stock off the support level. Once that motion of setting a resistance level and falling back to support is found, thousands of traders can zero in on the stock, creating a rolling stock. As the stock starts back up, all the short sellers become buyers and XYZ gains momentum. As it nears the resistance level of 58, the shorters start selling again and down it goes.

This pattern of running up, banging against resistance and falling back to support can repeat multiple times. As the pattern repeats, though, an interesting thing occurs. Usually we see the support level creep a bit higher each time and the resistance level come down a bit each time. Why? Suppose you bought XYZ on its first run to 58 dollars, and then it dropped. What do you suppose you would do as it nears 58 again? Sell. That is why there is a resistance level - everyone trapped at the high wants to sell as soon as the price gets somewhere close. So we see selling begin at the 57 level. Eventually that becomes the resistance, and soon it is 56. On the other side, we see the support move a bit higher. That is because the short sellers do not want to cover right at support (it may not fall that far), and they buy just ahead of it, say at 51. Soon it will be 52, etc. But you may have had the chance to buy XYZ at 51 and sell it at 56 several times. Likewise, you may have had the opportunity to short it at 57 and cover it at 51 several times. This is a rolling stock.

If volume is strong enough, some major things can and often do happen. We may see the pattern "cone down" or, in other words, the distance between support and resistance becomes smaller and smaller. This is commonly called a "pennant formation" or a triangle. Once the tightening of the pattern gets so small on the "cone end" that there is no room left (say XYZ now has support at 54 dollars and resistance at 56), we are close to a big move. The stock may break out and run to the upside, or it may break down and fall. The break--in either direction--is usually a very strong one.

Other times the pattern does not come down much, but the forces are still in effect for a breakdown or a breakout. For instance, say XYZ has been rolling between 50 and 58 dollars for a couple of cycles before topping out at 57 and starting to fall. Naturally, the short sellers are hitting it pretty hard now, which is driving it down even faster. But suppose XYZ announces some great news like a stock split, and a tremendous amount of new buyers appear. Guess what? XYZ could be looking at a short squeeze. That is when an unanticipated event drives up a stock that has a bunch of short sales in it, and all those short sellers have to buy XYZ at the higher price just to get out of the trade. For instance, say XYZ has fallen to 56 when it announces that Microsoft is investing $100 million in the company and everyone jumps into the stock. In no time, XYZ has broken through its old resistance at 58 and is heading higher on the momentum. The short sellers must buy, too, creating even more upside pressure. This is a classic breakout.

As you can see, locating the resistance level and the support level will allow you to "play the spread" between them. When the stock approaches either level, you will know that something is about to happen.