An inside view of support and resistance

Question

Dear Mrs. Coulling,

 I just finished reading your book and was very impressed. I believe that understanding the psychology of the markets is critical to become a successful trader. Right now I am a college student with only 1 year of trading experience. From what I have seen, candlesticks and price consolidation seem to be the most predictive and effective tools in the markets. Your book really makes technical analysis easy to understand and implement to a trading strategy. I think this book would be beneficial to all investors and traders.

However, I do have one question which I still can’t seem to psychologically understand and I was wondering if you could provide some insight or point me in the direction to understand it better. 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? 

Any help would be greatly appreciated.

Answer

Hi – Many thanks for your email and thank you also for your very kind comments about the book and I’m delighted that you enjoyed reading it, and I hope that you will find it practical and useful in your future trading. 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 and 200 SMA’s. The market stops, pauses and reverses at these key levels and confirm 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 favour 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! All best wishes and thanks for a great question. Kind regards – Anna

About Anna 1040 Articles

Hi – my name is Anna Coulling and I am a full time currency, commodities and equities trader. I have been involved in both trading and investing for over fifteen years and have traded many different financial instruments, from options and futures to stocks and commodities. I write and publish articles ( mostly for free ) for UK and international publications on a wide variety of financial issues, and in particular I enjoy helping others learn how to invest and trade.

2 Comments on An inside view of support and resistance

  1. Hi Anna, I have now read all your 3 books and I would just like to say well done and thanks for imparting your knowledge on VPA. I have been trading stocks on the ASX now for 5 years and have done okay but not brilliantly. I have been using a Bollinger Band volatility system which I felt really fitted with me and my beliefs. In the past month of the reporting season I have included VPA into my trading and it has given me the confidence and tools to take my trading to a new level, so thankyou. At the moment I am lucky enough to to have 5 months leave, so now I am looking at studying and then trading Forex. I think you telling readers not to give up your day job for trading are words of wisdom and I totally agree with you on this, I have managed to trade and work part-time and have not had the worry of trading to generate my income. I have signed up for your forex training room and am looking forward to the 1st session.Question Does the ASX have market insiders ?? Keep up the fantastic work. Regards Linda

    • Hi Linda – First of all thank you so much for your very kind comments which are much appreciated, and thank you also for buying all three books – I feel you deserve a medal for having ploughed through them all – so well done you:-) I hope that together they all made sense and weren’t too overwhelming. Yes – you’re right – I always advise traders to keep the day job, for as long as possible. Trading is stressful enough without the additional imposed stress of having to trade for a living. It never works. So you are doing exactly the right thing. The principles of trading are the same, whether you are an intraday trader or longer term swing or trend trader, so trading with slower timeframes while keeping the day job is a perfect combination. As you know from the books, I do try to offer what I believe is sound common sense advice – not everyone follows it of course!

      With regard to your question about market makers in the ASX, I have attached a link here to a ASX Market Makers PDF which lists the market makers for the exchange traded products – I believe that Optiver have recently withdrawn and no longer act as a market maker.

      I hope the above helps, and once again many thanks for your very kind comments – do keep in touch and let me know how you are getting on, and I look forward to seeing you in the forex rooms – all best wishes and wishing you every success – Anna

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