Re-defining Support & Resistance – Volatility Trading Part 2
Read Part 1 | The sandpiper & Trading – Part 1
Volatility Makes The World Go Around
Volatility is the most important technical measurement we can make as analysts. We are all familiar with the old saying, ‘money makes the world go around’. I now believe ‘volatility makes the world go around’. By my estimate I think this to be true beginning about 20 years ago. This owes mostly to the radical expansion of securitization which began in the 1990’s.
What does volatility have to do with Support and Resistance? You’re about to see. Strap on your thinking cap, this is likely to be conceptually new for you.
First let’s take a quick look at what we covered in the first article, which shed needed light on why volatility is so important.
For an in-depth definition of Big Money see the Lagniappe section at the end of this article.
Onward then . . .
Support = the price point where buying power (buyers) will overtake selling power (sellers), thus price declines no further.
Resistance = the price point where selling power (sellers) will overtake buying power (buyers), thus price rises no further.
Simple right? These price points are very handy to have identified. But is it really that simple? This definition is true but incomplete.
The definition ignores the time element. Support for traders who hold a position for 60 minutes, is not really support for traders who typically sell after 5 days. Short-term support/resistance is not equal to long-term support/resistance, respectively. However we mathematically identify support and resistance, there needs to be an important quality within it.
It must be Fractal.
That is to say it must work equally well, with the same rules, for all trading hold times – and by default for all technical charting timeframes.
Identifying Support/Resistance with Volatility Measurement
My method for accomplishing this is by using a set of trading bands I created which have very different properties than any others. Mine are called N bands; and yes the N stands for Northington.
Trading bands are typically designed to gauge the strength of a momentum movement. That’s because virtually all forms of classic momentum measurement struggle to do that. Classically one would use a Bollinger band or Keltner band to assist in that task.
N bands are designed to identify support and resistance for the ‘right now’ timeframe. If price touches the lower N band, or gets close, it encounters support; buyers begin to overpower sellers.
The above chart of Microsoft (MSFT) [65 minute], shows typical N band behavior. The solid line is the N band, and the dashed line shows where the effects of resistance or support begin. Look how price lowers to the ‘support zone’ then goes no lower.
Note: Keep in mind that no technical measurement is absolute in its performance. Also remember that 50% accuracy is the point of uselessness; which is to say statistically random. The closer to 100% the better.
This is what’s different about N bands. They are designed to contain price, while other trading bands are not.
This is very useful. N band zones make very good exit points. They make even better exit points when plotted in a higher timeframe. Suppose in this case you normally trade from 15 minute charts or lower. A long exit at N band resistance, plotted on a 60 to 65 minute chart is even more effective, as shown above on the 10th.
Think of the concept of:
“Short Term Risk with Long Term Reward”
What happens when price goes through an N band? Wouldn’t that be considered to be a failure? Yes, it would if that were simply the end of its usefulness.
Let’s say you do trade on 15 minute charts. See the example above.
Uh oh . . . looks like the price rise just mauled the upper N band. Failure!
Not so fast. When price closes outside of an N band it usually means trend change. Some might think this is trend change confirmation, and they are not incorrect from one viewpoint. My belief is trends only change when they breach real support or real resistance. Increased accuracy of predicting trend directions is a major component of technical trading.
See the point where price closes above the upper N band? That tells me the odds are in my favor price will continue in that direction. It means strength because buyers way overpowered sellers.
Also remember the best practice is to exit at N band resistance in a higher timeframe. A good rule of thumb is 4 to 5 times higher. In this case a 60 minute to 75 minute chart would show best probability exit points.
Use support/resistance in normal charting timeframe for stops.
Use support/resistance in higher charting timeframes as exit points.
This achieves: “Short Term Risk with Long Term Reward”
If we can identify, with probability, current support/resistance, can we also identify future support/resistance? Yes we can.
The key to predicting future support/resistance is to use the peaks and troughs of the N bands. It’s really as simple as that. Only the extremes matter – in so many ways. What follows is proof of this concept. Once again let’s look at the MSFT 65 minute chart below:
To help prove an extreme, think about the definition of peak and trough. The concept of peak and trough may seem straight forward at first; but there are a few important characteristics.
peak = a high point, which precedes a low point, where the new low is lower by some predetermined amount – such as a percent of movement or a fixed quantity of units.
trough = a low point, which precedes a high point, where the new high is higher by some predetermined amount – such as a percent of movement or a fixed quantity of units.
Thus peaks and troughs are quantified extremes. The only other important point to make is the method to quantify the extreme (the amount of retracement required) should identify a significant extreme. That is to say not every little up and down that occurs.
On the chart above the peaks and troughs are notated. Once the peak is confirmed by an adequate retracement, a corresponding resistance zone is projected forward. If price were above the zone then it would be support. The same applies to the troughs.
The predictive part is possible because the zone is established as soon as the peak or trough is confirmed. See how price responds to the zones on the 17th and the 18th? Price pauses or reverses at the resistance and support zones.
It’s also important to point out that when price is above an SR zone, then the SR zone is support. When price is below an SR zone, the zone is resistance.
Money is Made at the Extremes.
Yes, the extremes are what matter most. These points make the most profitable entry and exit points. A rewarding experience is had by identifying real extremes as opposed to false extremes.
Below is another example comparing classically drawn trend line resistance and Volatility-Based Support Resistance (VBSR):
The ASX 200 Index above shows a break at a resistance trend line. Simple, right? One could easily make the case the trend is likely to change upon several bar closings above the break – and subsequently enter a long futures contract position.
Certainly the trend momentum changes due to the break. However for the trend to change, real (meaningful) resistance should first be broken.
As you can see, the ASX Index halts its rise when it reaches the SR 3-4 resistance zone. Should price climb above the SR 3-4 zone, the probability of significant trend change is likely.
In this case the SR 3-4 zone was confirmed and plotted on market close of 2015/6/22. It occurred because the upper N band confirmed a new trough at that point. The new trough was a new volatility extreme.
Volatility Extremes are Real Extremes
20th century technical analysis depended on a very linear way of looking at price information. In the 21st century, Big Money moves markets, and most individual securities exchange traded and over-the-counter (OTC). Big Money decisions are most heavily influenced by volatility calculations.
Volatility-Based Support Resistance (VBSR): Why does it work?
I must say I can only answer this question with a thorough explanation. That is to say, “the devil’s in the details” – or perhaps more accurately stated, “the angel’s in the details”.
So put on your thinking caps and absorb this:
N bands are a proxy representation of consolidated levels of implied volatility. Expressed as price levels (not %), designed to approximate volatility limits of similar contract expirations to that of the chart periodicity (timeframe; daily, weekly, etc.). In that way it is meant to be a ‘view’ of consolidated implied volatility.
It is the extremes of the N bands which are most significant. The ‘peaks’ and ‘troughs’ of the N band levels represent the extremes of concentrations of investor commitment, in the form of contract valuations (due to valuation models and their dependency on the volatility input), reaching points where decisions need to be made and action taken.
Concentrations of commitment at key price levels are what support and resistance is made of. This is because it’s at those levels where buy/sell decisions must be made.
Whew! So much for the heavy talk!
In our next article we’ll dissect the above theory and show how it maps to the real world. We’ll do this by looking into one of my favorite subjects: the market micro-structure. Throughout I’ll show practical trading methods for VBSR and Northington Dahlberg Tools.
Read Part 3 | Risk & Reward
Big Money: What’s it made of?
G-SIB (Globally Systemically Important Bank)
G-SIB definition: [Basel Committee on Banking Supervision ]
A G-SIB is defined as a financial institution whose distress or disorderly failure, because of its size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.
Size of G-Sibs; relative to their respective local economies
As of October,2011, the top 40 G-SIBs possessed or controlled 57.75% of the total financial assets of their respective economies.
Kirk Northington, CMT
Co-founder of Northington Dahlberg Research, LLC
Kirk is a co-founder of Northington Dahlberg Research, LLC and is a quantitative technical analyst. He is a member of the Market Technicians Association, and is a Chartered Market Technician. Kirk is a frequently requested speaker on the topic of volatility trading and volatility based market analysis.
He is the author of Volatility-Based Technical Analysis: Strategies for Trading the Invisible, Wiley Trading Series, John Wiley & Sons Publishers; in which he pioneered new concepts in technical and quantitative analysis. Kirk has a BS degree from Nicholls State University, in Thibodaux, Louisiana. He has extensive experience in institutional market risk, process control system design, and software engineering.