The Psychology of It
Here’s an explanation of why support and resistance work, which also accounts for the way that they reverse roles once they are broken. It is an oversimplification, but, as it did with me, I hope it shows you a way of thinking that is enlightening. Trading and the way the markets move has little to do with the mechanics and mathematics of the process, and much more to do with the psychology of the other market participants. That’s why you can learn about trading the stock market and apply the same principles to trading the Forex markets, the commodity markets, and all the other types of market that spread betting allows you access to.
It is easiest to just to divide potential traders into three groups – those who already have brought (long), those who have already sold (short), and the rest who haven’t made their mind up yet which way to bet. Now you need to put yourself in their shoes and imagine that what they are thinking as they watch the price movements. Suppose that the price is increasing off a support level.
The ones who have just bought must be feeling pretty good now. They have made what looks like a good bet, they are on the right side of it, and they may even be wishing that they had bet a larger amount. They don’t really want to buy any more now the price is going up, but if only the price would come back down to where they originally bought, they might buy some more.
Not so with the second group, who took a short bet on the shares, only to see the price go in the wrong direction for them. If they close their bet now then they will have to take the loss, and no one likes doing that. I expect that most of them will hang on to see if the price comes back down, and then they will hurry to close a bet and not lose too much.
What about the third group, the ones who could not make up their mind? Well, to them it looks like the shares are in an up-trend and they may have missed out. They don’t really want to place a bet at a higher level, because that hurts when they could have bet previously at the lower price. Perhaps they will place a watch on the price, and if it comes back down to where it was before, the support level, then they will go long.
Look back over those three reactions to the price. Do you see how, whatever side these traders are looking at, it has the same result? All the traders are looking to take a long position if the price comes back down to the support level. The first and third groups take a long position to increase their bet or to take out a new bet; the second group want to get out of their short position with minimal losses, and they do that by taking the opposite bet, the long bet, when the price drops back down.
Now if you know anything about supply and demand, you will know that all these traders wanting to take the same long position if the price drops back to its previous level represents an increase in demand, and this will tend to push the price back up. In other words, when the price drops down to the support level it is likely that the increased demand will make it bounce and increase again. It’s just simple psychology, and not magic.
You can apply the same logic if the bets were reversed. If the price is dropping from a high resistance level, then the sellers would be winning and wanting to buy more if the price went back up; the buyers would want the price to go back up so that they could sell without losing too much; and the ones that hadn’t taken a side yet might well want to sell short, if only the price would go back up. All of which means that there would be a pressure to sell short when the price went back up to the resistance level, which would tend to force the price back down again.
All of this explains why support and resistance levels tend to work. They provide support for a falling price, and resistance to an increasing price, which means the stock may trade in a range, or sideways, for a time. Perhaps even half the time or more, depending what you’re trading in. But sometimes the price will break through the support or resistance and be in a definite trend. You can use the same psychological considerations to see why the support or resistance level will reverse its role.
For this example, let’s assume that the price drops through a support level by a significant amount. Remember, this isn’t an exact science which means that there can be the odd price a little below support without considering that the support has failed. But in this case the price has gone well below, and stayed there for a few days. The price is no longer supported by that level, at least at the moment. Let’s look at what our three types of traders are thinking.
First, traders who went long, expecting an increase in price. Perhaps they saw where the support level had been in the past, and bought early, expecting a falling price to reverse. It turned out to be a bad idea this time. We’ll talk about strategies later, but it is usually dicey to trade early. Many traders recommend watching and waiting for the price to reverse before taking a position – you can lose out on part of the price move, but it is a safer way to trade. No-one likes to take their losses, so provided the price doesn’t drop too much these traders are prepared to hang on and see if the price goes up again. If it gets back up to the support level that failed they will gladly close their trade there and minimise their losses.
The second group, who had short positions betting that the price would fall, are happy to see the potential profits coming. Perhaps they wish they had made a bigger bet, but don’t want to increase it now the price has already fallen. They may keep watching, and if the price goes up to the old support level where they opened their bet then they might add to their short bet.
And the third group, who were still thinking about placing their bets, but hadn’t decided which way to go, are now thinking that a short position would have been good because there’s a down-trend forming. Perhaps they missed the boat, but if the price goes back up to the old support level then they’ll make sure they get some this time.
If you are following along closely, you will see where this is going. Each of the three trading groups is now looking to sell if the price goes back up to the old support level, and this “supply” will mean that the price is likely to drop. The old support level has become a new resistance level. The reversing in roles of the support and resistance levels is logical if you consider the thoughts and feelings of the other market participants.
“Support and resistance levels are useful but it is important to understand that no system is infallible and levels that have held repeatedly over the course of time can still be broken.”
The Strength of It
Now we come to the obvious question – when should you expect support and resistance to work, and when will it fail? I’ve already said above that you probably should wait for a change in the price in the right direction before trading on it, but that’s not the best of information, even though it’s a guideline that you will often follow. You really need to know how strong the support and resistance levels can be expected to be, or how likely is it that they will fail?
Of course, there is no clear answer to this – once again, if there was then everyone would be a winning trader, and that would lead to there being no opportunities for the smarter ones, like you and me! So we have to figure on a “balance of probabilities” idea, and bet with the odds. You will see later that this is a fundamental idea in trading, as no-one can be certain of the markets.
There are a couple of ways that you can determine how solid the levels are, and therefore how likely they are to hold whenever they are tested. They are based on common-sense, for the most part. You can start by looking at how often the price has gone to the level and bounced off. If it has happened several times, then it is more solid than if it has only been touched once, for instance. Incidentally, if there are several touches it also makes the level easier to determine and helps in your analysis.
Another factor is how long the stock price has been trading in that vicinity. If it’s only been there for a couple of days, then the support or resistance level is not so solid or established as when it has been around there for a few months.
A third factor is how recently that level has been visited. Every time the level is reached, and holds strong, we say that level has been “tested”, and if it has been tested and held recently then it is more likely to hold up to further testing.
Fourthly, you should make sure that you check the amount of trading volume that happened when the level was reached. Any time you see a lot of volume, you can be sure that you are getting the majority vote of the market. On the other hand, if there is a light volume of trading, that should make you cautious of what the prices are telling you. Volume is an important part of the data available to you, so you must be sure not to make the mistake of looking only at the price action.
Finally, as mentioned above the support and resistance levels tend to be around whole numbers. So the obvious conclusion is that if the support or resistance you are considering is around a whole number, it is likely to be stronger and to hold for more times or for a longer period. These are all factors you should consider when you are gauging how much dependency you can place in on the levels of support and resistance that you have observed.
You should note that if you want to get out of the trade because you think it is coming up to a resistance level, or dropping down to a support level, you must keep this whole number thing in mind. If you really want to close your trade it’s worth doing so just before the whole number is reached, just to make sure that it happens. You should place your order to get out just before the whole number so you can be more sure it will take place. Given the variability of trading, you might find that the number is not quite touched and you will be left in your trade as the price rebounds, taking away your profit.