An Inside View of Support and Resistance
09/05/2014 6:00 am EST
Anna Coulling of AnnaCoulling.com shares a recent question-and-answer between her and a subscriber about support and resistance levels and the psychology behind this as a self-fulfilling prophecy.
Question: While trend lines and support and resistance seem to be widely regarded and I use them frequently, the psychology behind them does not seem to be clear. I almost believe at this point they are just a self-fulfilling prophecy because they are widely used. The famous saying that resistance becomes support once broken through just doesn’t seem to conceptually make sense. Why does it become support and often provide a bottom for the next pullback. Do the institutions leading the market really use charts to buy the asset once they have reached that support?
Answer: Hi—Now, the question you raise is an interesting one and, of course, you are right in saying that in many ways support and resistance is a self-fulfilling prophecy. We are all looking at the same charts and, in many ways, the same theory applies to some of the iconic indicators such as the 100-SMA and 200-SMA. The market stops, pauses, and reverses at these key levels and confirms the iconic status of each once again.
Whilst this is also true with support and resistance, there is a more subtle reason that these price regions behave in the way they do, and is reflected in the price action of the congestion phase. What is actually happening here is the constant buying and selling of speculators and investors as the market whipsaws higher and lower. If we take a move higher first, the market reaches a selling climax or moves into a congestion phase and initially moves higher, drawing in more buyers. The market then falls, trapping these buyers in weak positions. More buyers come into the market seeing the lower prices and expecting a continuation of the move higher, which duly happens and reaches the same level as before at which point those buyers in weak position sell, grateful to have closed with only a small loss or perhaps at breakeven. Those buyers who bought on the reversal lower are happy as they are in profit and even when the market reverses lower once again, their emotional response is very different. All they have seen is a position move from potential profit back to breakeven. Those buyers who bought at the top, have seen their positions move to loss immediately and then claw their way back to breakeven at which point they have closed out. This dynamic is repeated time and time again, constantly trapping traders in weak positions and creating the dense region of price action which then ultimately becomes support and resistance.
In other words, these are regions of the chart where traders in weak positions, either long or short, are now waiting for the price action to move in their favor to close out their positions. In addition to the above, many traders (myself included) will use these areas of price action to place stop losses, either above or below. They are natural barriers created by the market and if the market is moving higher away from a congestion phase, then a logical place for a stop loss is below the floor of this region, creating further regions of order density on the chart. This is similar in some ways to 00 and 05, which is where many traders place stops. The markets will always struggle and flirt with big numbers on the chart when moving from one number to another. A move beyond 17,000 for example on an index becomes a benchmark number which is likely to trigger stops and orders alike. The price action described above is equally applicable to a move lower when the market moves into a consolidation phase from a steep decline. Here traders are trapped to the short side, expecting a further move lower with sellers coming in on the reversal higher, and those trapped in weak positions closing out on the next reversal lower. You can think of support and resistance in terms of crowd behavior.
Finally of course, the market makers themselves are keenly aware of these regions and the density of buyers and sellers trapped there, along with the density of stop loss or limit orders. All of which makes these key targets and overlain with the self-fulfilling prophecy triggered by us all looking at the same chart. I hope the above helps to explain these regions in more detail—they are, in effect, the battlegrounds of the market makers and describe the battle lines for each skirmish in the war.
By Anna Coulling, Professional Trader & Blogger, AnnaCoulling.com