The $SPY has traded in a certain range for years, finally busting through resistance last year to shoot to a higher level. What causes this to happen? Why is buying into, and holding onto all-time highs, good trading?
The more times something hits a support or resistance level, the stronger that level becomes. Most traders deal in range bound securities because they think they know that a stock’s price is unlikely to exceed a strong resistance level. The more traders that recognize that fact, the more short sellers there are lined up to short the all-time high level. And the more short sellers there are, the more buy stops there will be set at that unlikely level, just beyond resistance by momentum traders, breakout traders, and some trend followers.
For example, if the $SPY has approached the same all-time high on many occasions, profit taking has become exhausted, and investor sentiment is more positive due to central bank support of the equity markets, media induced fear has probably caused everyone that wanted to sell to already be out. This causes:
- Demand for stocks to go up, as selling pressure dissipates and the remaining investors are just holding.
- All-time highs to be breached and, short sellers to be squeezed out as they are stopped out and forced to buy back to cover their short positions. This creates what we affectionately term a short squeeze. Everyone who thought they knew where the ceiling (resistance) was, no longer holds a position in that index. What once was the ceiling becomes the new floor, or support level.
Once a security breaks out above strong resistance, it takes some time to create and recognize the new ceiling. Short sellers become less likely to step in because they can no longer anticipate where the stock is likely to bounce back down. The term ‘blue-sky breakout’ is used to describe a stock that breaks above all previous resistance points. At all-time highs, there is no resistance, no stop losses being triggered, and only profit taking.
All-time highs are uncharted territory of price discovery. The next levels that trigger targets for profit taking are $205, $210, $220 and so on. The path above all-time highs is one of the easiest paths; above the charts and above resistance, there is nothing but blue sky.