Support and Resistance

As many traders are well aware, the market does not follow a random and chaotic walk which some academics and theorists would lead others to believe. Since the market is comprised of individuals who have emotions and a memory of the history of price, the price of a security is shaped by emotions and memory. In other words, the people who buy and sell in the financial markets are human: they do not enjoy losing money and they become greedy when they are easily making it.

The collective psychology of the market can be seen in both the trend as well as support and resistance. Support is where price has been falling for some time and then is halted or "supported" at a point or a zone. Resistance is where price has been rising for some time and then it is halted or its upward motion is "resisted" at a point or a zone. These points are typically drawn as horizontal lines while in a trading range and diagonal lines while price is trending upwards or downwards.

Support and Resistance

At this point, the reader may be asking himself: what causes these lines? Is there really order to the financial markets? The truth is that several things cause these support and resistance zones, but for the most part, it is a self-fulfilling prophesy. From the early days of technical analysis, support and resistance has been taught. Traders have been conditioned for decades by reading ancient manuscripts which noted that price is bound by support and resistance lines. With almost every trader on the market being aware of support and resistance, it becomes a self-fulfilling prophesy of sorts. This means that since trader believe support and resistance should support a fall and resist a push, they buy and sell in anticipation which in effect causes these zones to occur. Another reason and explanation for support and resistance is that large institutions typically place their orders at whole numbers, causing whole numbers such as $25.00 or 1.4000 to be strong support or resistance points. One final explanation is that support and resistance is caused by traders initiating losing trades and placing orders on the market in frustration declaring "if I can just get break even, I'll sell". This theory is that many traders wishing for better prices or past prices cause the market to have a "memory" and bounce off of areas and zones where these orders are grouped. Since the markets clear millions of dollars every hour, this explanation is likely not the case.

Trend lines

A trend line is a support or resistance line which is drawn diagonally with a trending security. A trend line is simply a line which shows where a trending price has the likelihood of finding support (while it is trending upwards) or finding resistance (while it is trending downwards). Trend lines are a widely used method of the technical trader and many securities can typically be found responding to trend lines. However, it should be noted that the capital markets seldom experience price change in a perfectly linear fashion and expecting the market to conform to a perfect line seldom pays out. However, if a trader were to create a system based purely on trend lines, he could profit assuming he only trades at the touch of a trend line and uses a stop loss to protect him should he be wrong. Through the ages, several wise saying have circulated around the trading community such as "trend lines are typically broken on the 4th touch" and "trend lines should be drawn with a marker rather than a line". In other words, the breaking of a trend line does not mean that the trend is over, but keep an open eye for a potential consolidation or reversal.

Trend line

Not all trends are as difficult to spot and trade as the one shown above. Below we have included a trend which is easier to spot and behaves in a more predictable fashion.

Trend line