Typically we can assume that only a handful of winning positions are going to generate the majority of your profits. There are certain lucrative trades that are naturally going to be home runs, and these are the ones that you want to be sure to ride for as long as possible. At the same time you want to ensure an appropriate level of discipline in your decision making, preventing you from lingering unnecessarily in a losing position. To ensure the very best exit strategy, you can manage your trailing stops point by point according to the level of technical support garnered by your position.
Levels of Support
A tight stop would be used with solid support, perhaps a two-point trailing stop, which could be loosened if your position continues to remain profitable over a longer period.
Support and resistance lines are your key indicators and any widely-available technical charting software allows you to plot (and refine) both these lines on any security's chart. Both support and resistance should be viewed not in terms of finite points on the chart but in terms of ranges of values. If your security has declined sufficiently to reach a level somewhere within your range of support, you are probably well served to adopt a looser trailing stop as significant strength may very well be evident in your position. By contrast, once your position is entering your zone of resistance, you would be well served to tighten your stops as much as is practical.
Trading on the basis of support and resistance levels naturally must incorporate volume because any security will only break through its level of support and resistance if sufficient volume is attached to it. Light volume may cause support or resistance trends only to pause while sufficient volume will cause such trends to reverse. Indeed, the concepts of support and resistance are based on reversals, where a trend will reverse on its upper end when it reaches resistance; and the trend will reverse on its bottom when it hits its range of support.
The Psychology of Support and Resistance
Support and resistance levels exist only by virtue of traders' and investors' memories of their experience of trading a given security at certain levels in the past. Investors will be more inclined to lend their support at the same level at which a large crowd of investors once purchased the stock. Traders tend to have the expectation that a stock will rise again from the same level as it did in the past. Even if those traders did not hold the security in a previous session, they will still look to history to be their guide, examining prior examples of session bottoms and levels of support.
You should also note that particular zones of support or resistance are expected to shift to their opposite once their zones have been broached. For example, a strong zone of resistance, once broached, becomes a psychological victory for traders and quickly turns into a zone of support for the ensuing trend as traders continue to celebrate the victorious breakout. By contrast, once a zone of support is destroyed, the psychological deflation is all too real as the chart stubbornly refuses to touch this zone again in the near future.
The psychology of support and resistance corresponds to the vicious emotions of pain and regret. Traders holding losing positions feel pain and, looking for the first available opportunity to lessen their pain, abandon their positions. Traders who missed a good opportunity feel regret and look to trends from the past to find new opportunities to make up for missed chances in the past.
Even in a flat market these emotions can be prevalent. Traders may practice buying at the lower edge of a range and shorting at the upper edge. In uptrends, bears who engage in short selling will naturally feel pain, and bulls will experience regret that they did not buy more. Both will be eager to buy if and when the market gives them a second chance, which will create support during investors' reactions in an uptrend.
Resistance indicates bulls feeling pain, bears feeling regret, and both camps ready and waiting to sell. A downward breakout from a trading range will cause pain to bulls who bought and will make them eager to sell during the first market rally so that they can get out even. Bears will regret not shorting more and wait for that same rally to allow for a second chance to sell short. The pain of bulls and the regret of bears in a downtrend translates into what is referred to as resistance.
(by Jason Van Bergen)