Valid penetration is an optimal method in determining a support/resistance level as broken.
When a support level is validly penetrated, it is expected traders will now treat that level as resistance. When a resistance level is validly penetrated it is expected that traders will now treat that level as support. There is no hard and fast rule for valid penetration; however, you can objectify your interpretation. Personally, I have found to be sufficient is either a successive three-day close over or under major levels or a 3% close over or under major levels. Minor levels require a less considerable close above or under the level. A 1-2% penetration is usually sufficient. The closing price of a stock is the most important price at any given time. It is used as a reference point for analysts to determine the performance of a security over a specified period. Therefore, intra-period penetration of a support or resistance level is not as significant as a close over or under these levels. Valid penetration criteria should account for violation on a closing price basis.
Let’s go over an example of valid penetration criteria. Let’s assume that stock XYZ has significant resistance at $100 and is currently trading at $95. For XYZ to validly break the $100 level, XYZ must close over $100 three-days in a row, or close at $103 (3% of $100). If this occurs, then $100 can now be treated as a major level of support, no longer resistance. If the $100 level were only classified as minor resistance, then a three-day close above or 1-2% penetration is still appropriate. If this occurs, $100 will now operate as minor support, no longer resistance. A support or resistance zone must be penetrated significantly enough to convince traders holding losing positions that they are incorrect in their analysis and look to exit their positions.
Short-sellers at a resistance level must be squeezed out to contribute to demand. When a short-seller buys back their position, it contributes to buying pressure/drives prices up. Buyers at a support level must sell their position for a loss. Buyers selling their shares contributes to supply/selling pressure (drives prices lower).
Your criteria for valid penetration may not align with mine. My criteria is relatively conservative; I prefer to cut a losing position short. That said, your criteria can differ from mine so long as it remains constant. We should not require 4% closing penetration of a support/resistance level for one security, and a 2% penetration for another. We cannot assess the efficacy of our strategy with this behavior.
Remember, trading is all about your edge. If our criteria for valid penetration is satisfied and we consider the level broken, this does not mean we are correct. For example, prices may trade slightly under a support level through five consecutive sessions. Our valid penetration criteria are satisfied as a result and we consider the level broken. However, prices subsequently move back over the level and execute an uptrend. How should we interpret such a sequence? Our precisely defined exit rules have been satisfied, and the edge our strategy provides is now absent. We cut our losses and look for another opportunity.
Figure 1.1 Valid Penetration – Support/Resistance
In Figure 1.1, stalls and reversals are marked which can be classified as support and resistance levels. Notice how the marked support and resistance levels consist of a line and an oval. The line indicates the exact price level where support or resistance formed. The oval indicates where prices are likely to stall or reverse if the same support or resistance level is tested again and momentum fails. For support levels, the bottom portion of the oval, below the line, indicates where prices may penetrate the level before stalling or reversing. Remember, prices can slightly penetrate a level before stalling or reversing. We are focused on identifying valid penetration. If prices validly penetrate the level (exceed the oval), it is likely the price move will continue. For resistance levels, the upper portion of the oval, above the line, indicates where prices may penetrate the level before stalling or reversing. Again, valid penetration is our primary concern.
In figure 1.1, the marked support and resistance zones were contingent on stalls and reversals due to increased buying intensity during a price decrease and increased selling intensity during a price increase. Excluding the $25 resistance level, the marked levels are all minor. Price movement of $BAC tested and failed twice near the $25 price level. I marked both of these failures as resistance points. Similarly, $BAC found support near the $20 price level, as indicated by the early March and mid-April ovals that are marked “support.” Eventually, price movement did validly penetrate the $25 resistance point. $BAC then failed to sustain these relatively high price levels and gapped back down.
Figure 1.2 Range-Bound Market Valid Penetration – Support/Resistance
In Figure 1.2, the $99 price level can be seen functioning as major resistance for $MCD. I determined this as a major resistance level for two reasons. The first is that price movement failed at this level on three consecutive occurrences. The second being that the level formed on high volume in September and an exceptionally high volume test of the level occurred in late November. Prices bounced off resistance subsequently. In March, the major resistance level is once again tested on extraordinarily high volume. However, prices fail to validly penetrate and bounce off the resistance level.
We can trade this major resistance level with everything we have learned so far; however, prices are range-bound and we should supplement our approach with an oscillator to achieve definitive buy/sell signals. See the test in late November? What formation is that? It’s a shooting star! We know the implications of that formation, and it formed on “mind-blowing” volume. The intrasession high price (shooting star upper wick) was above the major resistance point. However, prices closed below the resistance point on inordinate volume. How do we interpret this? Selling intensity at prices above the resistance level is exceptionally strong.
Think of it this way. We can distinguish a major resistance level in mid-September; selling intensity strongly exceeds buying intensity at the price area. A shooting star forms at the level, the upper wick extends above the resistance point, and prices close below resistance on extraordinary volume confirming supply > demand is still occurring. This can be perceived as a short opportunity. If resistance is validly penetrated, we close quickly. However, you can see our immediate judgment was correct; a good amount of profit could have been realized.
The test in March consists of two important sessions. The upper wick of a narrow-spread candlestick extends above the resistance level; however, prices close beneath resistance, reflecting increased selling intensity at prices above the level. The subsequent session incorporates a bearish engulfing pattern on average volume. This could have been perceived as a potential short opportunity. We can identify two major support points in this sequence of price moves. Buyers regain short-term control of the market on several tests of the $93.99 major support level. Similar results occur at the $93.14 major support level.
There are a few critical sequences on this chart that are important to discuss. First, look at price movement in early February at the $93.14 support point. Prices open below the level on several sessions and even close below the level for one session. Now, look at the dashed line. The dashed line indicates a 3% valid penetration point of the $93.14 major support level. For the second major support level to be validly penetrated, prices must close at or beneath the dashed line or close below $93.14 three-days consecutively. Neither occurs. Prices bounce and eventually retest the major resistance point on high volume. Now, look at when prices validly penetrate major resistance in April. The 3% valid penetration point is not met; however, prices close above the major resistance level three-days consecutively. We can consider this level validly penetrated.
Prices peak and form a resistance point, fall, and retest the previous resistance level. Remember, when a resistance level is validly penetrated it often converts to support. Buyers regain control as the newly converted support point is tested and an upside breakout transpires. It is customary for a validly penetrated major support or resistance level to be tested before prices continue trending. Why does this happen? A large portion of traders who went short at a validly penetrated resistance level are looking to close. Many of these traders will capitalize on prices retesting the violated resistance level to close their position for a negligible loss. Remember, when shorts close their position, they must buy back the shares they sold. This contributes to demand and drives price higher.
Many traders who went long at a validly penetrated support area are looking to close their position at a negligible loss. If prices retest the violated support level, many losing buyers will look to sell their shares, which contributes to supply. This sequence makes it difficult for prices to move back above the support level.
Practical Use – Straight Talk
There are no hard rules with valid penetration – application is subjective. However, we can objectify our approach by laying out valid penetration rules and adhering to them.
The rationale of valid penetration is that buyers sell after prices break a support level, which contributes to supply/selling pressure. In addition, short-sellers at a resistance level are squeezed out of their positions when the level is broken, which contributes to demand/buying pressure.
This makes sense.
However, valid penetration rules are advantageous in another way – risk management.
You can close your position when am S/R level you entered at is validly penetrated. No deliberation required.
You’ll be forced to identify valid penetration quite a bit throughout your trading career. Make sure to construct rules now and consistently adhere to them. You can always refine your interpretation in the future.
Try to objectify your trading!
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