How Support and Resistance Areas are Created

Question:

Hi Lance,

In his text on support and resistance, Mike Reed talks about traders hoping the market will return to a level of support or resistance  so they can break even in that trade. So are levels of support and resistance more to do with the behavior of traders than the actual value of the dollar,

Thanks from Brian. 

 

Answer:

Hi Brian,

Support and resistance are only about the behavior of traders – nothing else.

This is a big topic which won’t be adequately addressed by a short email, but hopefully a summary will make it sufficiently clear…

Price movement is a function of the balance or imbalance of supply and demand. This supply/demand imbalance changes based on the sentiment of the market participants. More bullish sentiment and price rises. More bearish sentiment and price falls. Support areas are areas which have objectively shown an increase in bullish sentiment. We know this because price rallied from that area. Resistance areas are areas which have objectively shown an increase in bearish sentiment. We know this because price fell from that area. (See any material by Sam Seiden on this topic – he teaches it better than anyone else I’ve read).

Now consider a trader conducting analysis on the market with the view to trading. What creates the support and resistance areas are the heuristics and cognitive biases that are part of human decision making. Of particular interest here is the anchoring bias. There’s a whole heap of others which influence our decision making, including the formation of support and resistance, but this is the main one for s/r.

There is no absolute scale that can be used to determine the value of a tradable instrument. Overpriced or underpriced is determined relative to previous price action. So, in the absence of a scale, our mind needs to create a reference point (an anchor), which is a fixed point from which it can then determine whether a security is overvalued or undervalued. The points that stand out are the swing highs and lows, in particular those which create support or resistance areas.

Consider a stock channeling between lower support and upper resistance. Prices towards the lower end of the range are considered good value, because it’s close to the anchor from which price has previously rallied. As price gets higher though, it is perceived to be less of good ‘buy’, as it is further from the good value area. And in fact as it approaches resistance, it’s not a good buy at all, because our mind sees it as being at an area (reference point / anchor) which we’ve determined is overvalued, due to past evidence of price falling from that point.

So, those in a trade in the long direction will be looking at the previous resistance area as an opportunity to lighten their position, if not exit entirely. (That of course goes against the whole idea of letting trades run, but there’s other biases which make it ‘human’ for us to want to get out of our winners rather than letting them run). Other traders will be looking to enter short at the resistance. Both these actions, taken due to decisions influenced by the anchoring bias, lead to the spt/res continuing to function in future.

Why does resistance, once broken, become support. The perception of value now changes. The rally as price breaks through resistance is quite painful to those who went short, and took a loss. It’s even more painful to those who closed their long positions and missed the extra profits. They now see this area as providing great value, and swear to the market Gods that if price can just get back to that area they’ll never be so stupid again. So when it drops back to that new support area, these traders go Long.

Quick summary of a fairly advanced concept. Hope it helped bit.

You did mention price though, so I should point out one thing regarding price. Round numbers can also be subject to the anchoring bias. For example, the difficulty in Gold getting over $1000. It’s such a psychological barrier – five figures seems much larger than four figures – so we perceive anything over $1000 being overpriced, thereby creating resistance. This was seen as well when the Dow spent years trying to break through 10,000 for the first time. It’s the same reason why products sell for $97 instead of $103.

 

Question:

Hi lance, I have now read your response to my question regarding support and resistance several times and its really starting to make perfect sense. But lance, if s/r  are man made, and it now seems they are, why then do areas of s/r get penetrated. I mean what drives a currency up through a resistance area? Cheers and thanking you for your help. from Brian

 

Answer:

Hey again,

What drives price through a support or resistance area? Changing sentiment, as the information provided to the market changes. (NB. Changing sentiment refers to the resultant sentiment of all market participants as a whole).

Remember, there are market participants trading (or investing) based on numerous different analysis techniques, some of which (like the fundamental analysts) may have no idea where chart-based support or resistance are at all. And they’re also trading over different timeframes. For example, someone trading on daily charts probably won’t care where the 2 minute resistance is, unless it also coincides with the daily levels.

But regardless of the analysis methodology of the individual participants, the information presented to the market is constantly updating, and something has changed to cause enough of the participants to change their sentiment, allowing price to rally through resistance, or fall through support.

It might be fundamental, such as a Fed report, or interest rate decision, which changes people’s future beliefs. It might be technical. For example, let’s say a market is repeatedly testing a resistance level, each time with a smaller and smaller retrace (ascending triangle), many chartists will start to expect a failure of the level in the near future.

Markets are just people. Changes in price are simply the result of changes in sentiment of the market as a whole. It’s all about people and how they make decisions. Understand how other traders will make their trading decisions and you will find an edge – because we’re trading against those other traders, not against the market.

Cheers,

Lance Beggs

 


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YourTradingCoach – Admin

2 Comments to “How Support and Resistance Areas are Created”

  1. Marcus says:

    I cannot understand the mentality of the individuals who choose to stick through a drawdown in hopes of breakeven or even profit. If it goes wrong, you now have extra loss on top of whatever commission you have to pay to exit. In my opinion its always seemed better to miss a move for the sake of capital preservation rather then holding through drawdown hoping for nothing but luck at this point.

    • Lance Beggs says:

      It amazes me as well Marcus. One thing I’ve never had a problem with is cutting a loss quickly. I’m very risk averse. I guess I’m luck in that regard.

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