Monthly Archives: July 2008

Support and Resistance – the Greatest Trading Tool

Despite all the hype from the internet marketers who try to sell you the latest trading ‘secrets’, the fact is there are NO secrets.

  • Identify setups which provide the potential for lower risk and/or higher probability trades.
  • Enter and manage those trades in a consistent and disciplined manner.
  • Minimize risk.
  • Manage your money.
  • Manage your emotions.
  • Journal your results, and review them to identify what’s working and what’s not working.
  • Keep doing what is working, and
  • Improve what is not working.

 

If you’re not trading successfully, it’s because you’re not doing one (or perhaps all) of these things.

There are no secrets!

So, it’s time to stop searching for this holy-grail solution and get down to some good old-fashioned work.

And where better to start than the first item on the above list – a setup which provides the potential for a lower risk and/or higher probability trade.

Every technical analysis book on the market shows a number of charts with horizontal lines, and labels them support or resistance. Why is that? Because they look cool, and you can show your friends how clever you are at analyzing the market? Well, yeah, perhaps that’s part of it. But have you ever really stopped and asked why you should care if the price action can be bounded by a line? What does it really mean if price has been unable to break through a particular level in the past? Why should you care if price consistently rallies every time it falls to a certain level?

The reason we care is because support and resistance are providing you with setup areas with the potential for lower risk and/or higher probability trades. While there are numerous ways to define an area of low risk and/or higher probability trading, I have not personally found one that works for me as well as the concept of support and resistance.

So, how do support and resistance work?

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Trader Q&A – Price Action

Today’s Q&A is a VERY recent one. It just happened today, but it’s such an important question I thought I just had to add it to the newsletter.

Question:

Greetings, Lance.

I enjoyed and learned a lot from reading your best article: Price Analysis – A Top Down Approach. An experienced trader mentioned to us that it is a must-read for any aspired scalper who wants to understand what is a good approach.

Something hanging me in the air in the article though is about reading price actions of the swing momentum and volatility in order to know the strength of trend. Would you spare a few more words on this subject?

Thank you.

 

Answer:

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Why Price Moves – An Introduction

You’ll find in many trading books, websites or courses a statement to the effect that ‘price rises because there are more buyers than sellers’, or ‘price falls because there are more sellers than buyers’.

While I understand what the author is trying to say, it’s not quite correct.

There are not more buyers than sellers, or more sellers than buyers. Any transaction involves both a buyer and seller. The number is the same – one buyer and one seller. So, across the whole trading session, the number of buyers will always match the number of sellers. It’s fairly obvious when you think about it.

So, why does price move?

Let’s move away from the markets for a second and think of a housing auction. Someone starts off the auction by making a bid. But the auction process doesn’t end there. A second bidder soon comes into the market and outbids the first. Why do they do that? They want a piece of the action. They want the ultimate prize – in this case, the house, and they’re willing to pay a higher price to get it. Then another bid comes in higher, and again, and again.

At some point it will come down to two parties competing to get the house. Eventually, one party gives up – they’ve hit their limit and won’t pay any more, so they drop out of the auction. There are no more buyers, so price doesn’t go any higher.

So price rises only while there are people willing to pay a higher price. Once no-one is willing to buy at a higher price, price will stop rising, and the house will be sold. The winner is the one most desperate to get the house.

The financial markets work through a similar auction process, except that it works in both directions, up and down.

At any given moment there is both a bid and an ask price. A number of buyers are sitting in the market trying to buy at the bid, and a number of sellers are waiting, trying to sell at the ask. Sitting on the sidelines as well is a quantity of people waiting to enter the market, either through a buy or sell transaction.

Which way price will move from here is a function of which side is more desperate to make the transaction. If buyers are not desperate to buy they will place their orders at the current bid, or lower, and wait for a seller to hit their price. However if buyers are desperate to get into the market – if they perceive the price as being great value and are willing to pay a little more because they want in – they’ll be happy to take the ask price. If this happens in sufficient quantity to exhaust all the sellers at that ask price, then the ask price will rise to the next group of available sellers. The desperate buyers will now have to take even higher prices, if they still want to get into the market. So, price rises while the buyers are more desperate, or more eager, than the sellers. Price rises while there is more demand for buying, than there is for selling. Price rises while the greed of market participants is greater than the fear of market participants. Price rises while buyers are willing to pay a higher price to get into the market.

As price rises though, fewer buyers will perceive value in buying this high, whereas more sellers will be attracted to the higher prices. Eventually, the market runs out of desperate buyers – no one is willing to pay a higher price at this time – and the rally will stop. Equilibrium has been reached.

Consider now, what happens if the sellers decide they have to get out, for whatever reason – perhaps they believe price will shortly fall. They become desperate enough to accept the bid.  If this occurs in sufficient quantity to exhaust the buyers at this bid price, the bid price will move down to the next group of buyers. If the sellers are still driven by fear of missing out on a sale, they’ll then have to accept the lower bid, again driving prices lower. So, price falls while the sellers are more desperate, or more eager, than the buyers. Price falls while the fear of market participants is greater than the greed of market participants. Price falls while sellers are willing to receive a lower price to get out of the market, or sell short.

As price falls though, fewer sellers will perceive value in selling this low, whereas more buyers will be attracted to the lower prices. Eventually, the market runs out of desperate sellers – no one is willing to sell at a lower price at this time – and the price fall will stop. Equilibrium has been reached.

So, basically, price rises when demand is more desperate than supply. And it rises to a point at which there are no more buyers willing to pay a higher price.

And price falls when supply is more desperate than demand. And it falls to a point at which there are no more sellers willing to sell at a lower price.

That’s why price moves. It’s not because there are more of one side than the other. It’s because one side is more desperate than the other.

Happy trading (not too desperately though),

Lance Beggs