Speed resistance lines (SRL) are especially useful when looking at issues that are inside of strong trends. A chartist uses the SRL to determine support and resistance, and can be used by those interested in both short and intermediate phases as well as long-term outlooks. Simply put, the SRL measures the line of an uptrend or a downtrend.
Developed by the late Edson Gould, SRL is constructed by drawing a line from the most recent high of the uptrend down to the low of the same trend. Then you must divide the line into a third and then again into two-thirds. Having this done, the chartist will draw a line from the low point of the trend through these two points. The lines you have now created show the possible support on retracement. When studying a chart wherein a downtrend is occurring, one needs simply to reverse the process just discussed: every time an issue creates a new high or a new low, the speed resistance lines must be redrawn.
In Stocks and Commodities Magazine, Jayanthi Gopalakrishnan writes, "If you are considering entering a long position in a security that is rebounding from a downtrend, identify the major high and low, insert the speed resistance lines and the study the price action at the two-thirds line."
Some traders use a 50% retracement as a rule of thumb, and many agree that a pullback from a major trend will always be within a range of 1/3 to 2/3 of the most recent upward movement; the 1/3 level is the minimum an investor can expect. At this level of 1/3, a giveback and increase in trading volume will occur because of the increasing number of individuals that understand retracements and wait for them as an entry into the issue. Investors have also learned that, should the retracement continue to fall through the 1/3 level and past the one-half (50%) mark, the next support will be found at the 2/3 level. And again, for those of you looking at an issue that is currently showing a downtrend, the reversal is true.
|Chart Created with Tradestation|
In the first chart of SunMicrosystems Inc., the first line is drawn from about the $5 mark in early September 1998 to the high mark of the uptrend in late August 2000, which is at about the $69 level. The 1/3 SRL is then drawn off the major high and major low is the 2/3 line. As the tech stock bubble burst, SunMicrosystems started the free fall, and, as you can see, the stock price was buoyed for a period of time at about $42.
The price action then bounced back to a high of $53 on December 6 before continuing the slide downward. Seasoned technicians would have determined that, at this last high point on December 6, the trend reversed and not just as a correction in an uptrend. At the 50% retracement mark, no resistance was visible, and the same can be said for the 1/3 mark at the end of August 2001, when Sun was at $13. As the stock price fell with ease through the 1/3 mark, chartists would then have expected the stock price to drop to the levels at which the uptrend first started.
|Chart Created with Tradestation|
In the second chart of Canadian tech-giant Nortel Networks, we see a downtrend that started in late summer 2000 and bottomed out in October 2002, at about the 50-cent level. The 2/3 speed resistance line is drawn and the price action cuts through the line at about $1.50 in mid-November. As this was the first level of resistance, technicians waited to see whether or not investors were ready to come back into the arena of a somewhat risky penny stock. Little resistance was met here and the stock price continued to the 50% speed line, and it appears as though investors are ready again to invest capital in Nortel.
Speed resistance lines allow investors the opportunity to time their entry into an issue that they can determine has turned the corner of a downtrend and established a bonafide uptrend. On the flip side, it indicates to an investor holding a long position that the uptrend of that stock has run its course and that it is now time to sell.
The Bottom Line
Since we started with a quote from Stocks and Commodities writer, Jayanthi Gopalakrishnan, let's conclude with a few more of his words:
"If you are considering entering a long position...insert the SRL and study the price action at the two-thirds line. If there is enough resistance to stop prices from breaking above this line, do not enter long positions. Only when prices close above this line for two consecutive days should you enter your long positions. If prices seem to decline from or close to this line, you might consider entering short positions."