LAST fortnight we talked about trends and the importance of trading in the direction of the trend in the timeframe of your choice. Let’s focus on trend changes this time around. As the price of a stock approaches a key area (support or resistance) how is the market likely to behave? Will volume taper off and a counter-trend move begin? Or will new buyers/sellers come in and push the market through the key area?
Support and resistance: A simple way to think of support and resistance is that of a ball thrown up to the sky. The ball slows down as gravity takes effect and eventually comes to a standstill before falling back down to the earth. The turning point ("resistance") is where the force of gravity overwhelms the initial force.
As the ball hits the earth it encounters "support" which causes it to bounce. The bouncing continues within an ever narrowing range ~ the equivalent of a market consolidating after a big move ~ until another big force is applied.
What determines support and resistance levels? In short, greed and fear at various levels. Market participants are motivated by the desire to make money and, at the same time, by the fear of losing money. Resistance levels are formed by "passive" selling ~ profit-taking, inventory changing hands ~ and are broken by "aggressive" buying ~ new participants fuelling demand, sellers backing off in the expectation of higher prices.
Note the volume connotation of passive and aggressive behaviour ~ the former is marked by a tapering off in traded volume, the latter by a spike in traded volume.
Conversely, support levels are formed by passive buying ~ shorts taking profit ~ and broken by aggressive selling ~ new shorts entering the market e.g. big pension funds exiting equities for bonds, buyers backing off in the expectation of lower prices. As before, passive buying is usually associated with diminishing volume and aggressive selling with a volume spike.
The market has memory: Contrary to what economic theorists would have us believe, the market does have memory. This shows up time and again in all asset classes and all time-frames. It has as its basis fear and greed and market participants playing out their psychological games in the market.
It is this "memory" that makes a stock come back and retest a previous support or resistance, once broken. For example, when a stock powers through a key resistance level, it is common to see a pull-back to that level once the initial driving force has spent itself. In other words, a key resistance level, once broken, acts as support. Why does this happen?
It’s like a psychological hurdle has been cleared and money that was sitting in the sidelines rushes in. Potential sellers sensing the surge in demand back off, thereby limiting supply. Existing shorts find themselves "stuck in a hole" and rush to buy. This produces a squeeze that further fuels the up-move. Once the initial thrust is over, the market enters a period of consolidation. Remember that the function of a market is to find prices at which trade is facilitated. There could still be money waiting in the sidelines which missed the big move and is waiting to get in.
There may still be desperate shorts looking to exit at a better level. In other words, there are plenty of market participants who will "remember" the broken resistance level and will be looking to buy at that level. The market may well auction down to that level to check for buyers.
Similar arguments hold for a broken support. After the initial selling frenzy is over, the market will likely auction back up to the support.
Sellers who missed the leg down may well be waiting to join the party. Trapped longs may be desperate to exit. All these factors would likely make the old support a new resistance level.
Low risk entries: The objective is to find low risk entry points where the expected profit is 3-4 times the expected loss. This does not involve calling the exact top or bottom but does mean getting in as close as possible to broken support or resistance. Risk management, as we keep repeating, is key.
Notice: Trading options involve substantial risk of loss and is not suitable for all investors. You may lose all or more of your initial investment. Information shared here is for educational purposes only.
The writer is managing partner of a financial engineering company based in Italy.