What Is a Test?
In technical analysis and trading, a test is when a stock’s price approaches an established support or resistance level set by the market. If the stock stays within the support and resistance levels, the test passes. However, if the stock price reaches new lows and/or new highs, the test fails. In other words, a for technical analysis, price levels are tested to see if patterns or signals are accurate.
- A test, in technical analysis, refers to the ability of a signal, pattern, or other indicator to hold firm in subsequent price action.
- Several technical tests exist, including those specifically intended for range-bound versus trending markets.
- Tests are often used to confirm resistance or support levels in a stock or other asset.
Popular technical indicators that traders and investors use to test support and resistance levels include trend lines, moving averages and round numbers. For example, many investors pay close attention to the price action of major stock indexes, such as the Standard & Poor's 500 Index (S&P 500), Dow Jones Industrial Average (DJIA) and Nasdaq Composite when they test their 200-day moving average or a long-term trendline. More advanced techniques used to test support and resistance levels include using pivot points, Fibonacci retracement levels and Gann angles.
The below chart shows the S&P 500 testing its 200-day moving average:
Traders should monitor volume closely when a stock’s price approaches key support and resistance areas. If the volume is increasing, there is a higher probability that price will fail when it tests these levels due to increased interest in the issue. Declining volume, on the other hand, suggests the test may pass as the stock may not have enough participation to breakout to a new level. A stock can test support and resistance levels in both a range-bound market and trending market.
Range-Bound Market Test
When a stock is range-bound, price frequently tests the trading range’s upper and lower boundaries. If traders are using a strategy that buys support and sells resistance, they should wait for several tests of these boundaries to confirm price respects them before entering a trade. Once in a position, traders should place a stop-loss order in case the next test of support or resistance fails. (For further reading, see: How do I Effectively Create a Range-Bound Trading Strategy?)
Trending Market Test
In an uptrending market, previous resistance becomes support, while in a downtrending market, past support becomes resistance. Once price breaks out to a new high or low, it often retraces to test these levels before resuming in the direction of the trend. Momentum traders can use the test of a previous swing high or swing low to enter a position at a more favorable price than if they would have chased the initial breakout. A stop-loss order should be placed directly below the test area to close the trade if the trend unexpectedly reverses.