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Support and Resistance Homework

Rounded Tops and Bottoms

Last week we touched on the rounded top/bottom formation. This is a very popular and powerful trading formation; however many people have difficulty finding the “neckline” of the formation.

The main reason some folks have a problem identifying the neckline of a rounded top/bottom formation is because they are looking too hard. As many of you know, if you stare at a chart long enough you can see almost anything you want to see – but the problem is that what you see may not actually be there!

Such is the case of the rounded top/bottom formation. People will hunt so hard for a neckline for a rounded top/bottom formation that they will end up placing the line just about anywhere.

In fact, over the years I’ve seen traders put rounded bottom necklines at secondary support/resistance levels, retracement lines, gaps, and a whole host of other areas in an attempt to identify the “neckline”.

Now don’t get me wrong. You CAN use any of the aforementioned areas to structure a trade from; however it will not be a rounded top/bottom formation trade. A rounded top/bottom formation’s neckline is actually quite simple to identify. The neckline of a rounded top/bottom formation occurs where the formation began. Actually, for our purposes, the neckline of the rounded top/bottom formation is the support/resistance nearest where the formation began.

So in the sugar chart assignment, you should have seen two formations like the following:

Now you could have drawn in a bunch of mini-rounded tops/bottoms; however keep in mind that the “real” rounded top/bottom always goes back to where the formation began.

This week saw sugar break through the neckline of the larger rounded top formation; however when it finds support you can rest assured that it will likely attempt another rounded bottom formation.

So where would the neckline of the eventual rounded bottom be?

Now you might say “Erich, that line’s a long way off, how is that going to help me trade today?”

Good question. Keep in mind that once the market finds support, which from the look of the long term chart should be fairly soon, this will be our next long term upside target. Given that this target is on the weekly chart it could easily take six months to a year (or more) to eventually find the target; however you will know where the market is heading over the long term!

This is why it is important to consider your longer term charts in your analysis, it helps you focus on the predominant direction the market is taking. You need to have the long term perspective in the back of your mind as you plan your trades so that you can best take advantage of the longer term trend.

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