The Reflexive Theory Of Support And Resistance

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Applying Reflexive Support And Resistance

The Reflexive Theory Of Support And Resistance

Support and resistance are very important factors of techinical analysis. In practice these levels produce areas where signals, reversals, pauses and other technical indications are likely to happen. On a chart a support or resistance line is a line,usually horizontal, that marks an area of previous reversal, congestion or break out. What they are really marking are areas, price levels, where the people in the market, those buying and selling stocks, view the market as either buyable or sellable. As mentioned previously, these levels can be previous bottoms or tops, the tops or bottoms of trading ranges, congestion bands or consolidations, break out’s from recognized chart patterns or break through’s of current support or resistance. Choosing the right places to draw your lines can be tricky, it definitely involves an element of art as there are NUMEROUS places on any chart where S/R could kick in. To learn more about how to draw S/R check out my article on How To Draw The Best Support And Resistance Lines. This article is more about how to use S/R in your analysis and specifically what I call the Reflexive Theory Of Support And Resistance.

The Reflexive Theory Of Support And Resistance

The theory is simple and fairly well know amongst technical analyst although you may not find it under this name. However, when support is broken it can become new resistance; when resistance is broken it can become new support and this is something I learned in the very earliest days of my trading. How is it possible you may ask? First, this is not 100% correct all the time which is why I say “it can become new support”. To understand lets start with what support and resistance really are. I know I have said they are areas on a chart where buying or selling is taking place but what spot on a chart is that not happening? To be more to the point these areas are where significant buying or selling is taking place or has taken place in the past. These levels are usually a price level indicated to be important by multiple types of analysis including but not limited to fundamental, valuation, momentum, sentiment, fear and greed. For one reason or another a significantly large portion of the active market participants in a stock want in or out.

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From a buy side perspective these areas become support. As prices reach the indicated price level buyers step into the market ranging from long term all the way down to the very nearest term day traders and scalpers, depending on the price level. As more and more buyers buy, the market balance swings into their favor, they overpower the sellers and begin to move price up. From the sell side these areas become resistance. As prices reach the indicated level profit taking, short selling or loss recovering takes place, bringing sellers into the market. As more and more sellers sell the market balance shifts into their favor and prices go down. Needless to say there are a lot of emotions involved with this as well. When support holds, euphoria builds in the market and greed helps push it higher. When resistance holds people get cranky as their positions lose money which causes some to escape the market in fear.

This is how it works. First, keep in mind the two sides of the story, support and resistance. When prices reach a potential area of support and resistance a battle ensues between the bulls and the bears. Bulls buy, providing support, bears sell, providing resistance. In the case of resistance, if there are enough buyers that they eventually overcome the sellers then it is possible for prices to break through. This is because the market balance shifted into the favor of the bulls. At this time the bears will stop out or cover their positions, adding their weight to the move which can sometimes result in very sharp market movements. Now, this is where the reflexive theory really comes into play. After the break through the market balance is 1) in the favor of the bulls 2) accelerated by the bears getting out and 3) now an attractive place for the market to get in. Bears may change their opinion and become bulls, traders sitting on the sidelines may decide to get into the market and where day traders and momentum seekers may find ample opportunity. The point is, the previous area or price level that provided resistance is now an attractive to place to enter the market because it is where the Bulls overpowered the Bears.

Support and Resistance Basics

The concepts of support and resistance are undoubtedly two of the most highly discussed attributes of technical analysis. Part of analyzing chart patterns, these terms are used by traders to refer to price levels on charts that tend to act as barriers, preventing the price of an asset from getting pushed in a certain direction. At first, the explanation and idea behind identifying these levels seem easy, but as you’ll find out, support and resistance can come in various forms, and the concept is more difficult to master than it first appears.

Trading With Support And Resistance

Key Takeaways

  • Technical analysts use support and resistance levels to identify price points on a chart where the probabilities favor a pause or reversal of a prevailing trend.
  • Support occurs where a downtrend is expected to pause due to a concentration of demand.
  • Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply.
  • Market psychology plays a major role as traders and investors remember the past and react to changing conditions to anticipate future market movement.
  • Support and resistance areas can be identified on charts using trendlines and moving averages.

Support and Resistance Defined

Support is a price level where a downtrend can be expected to pause due to a concentration of demand or buying interest. As the price of assets or securities drops, demand for the shares increases, thus forming the support line.   Meanwhile, resistance zones arise due to selling interest when prices have increased.

Once an area or “zone” of support or resistance has been identified, those price levels can serve as potential entry or exit points because, as a price reaches a point of support or resistance, it will do one of two things—bounce back away from the support or resistance level, or violate the price level and continue in its direction—until it hits the next support or resistance level.

The timing of some trades is based on the belief that support and resistance zones will not be broken. Whether the price is halted by the support or resistance level, or it breaks through, traders can “bet” on the direction and can quickly determine if they are correct. If the price moves in the wrong direction, the position can be closed at a small loss. If the price moves in the right direction, however, the move may be substantial.

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The Basics

Most experienced traders can share stories about how certain price levels tend to prevent traders from pushing the price of an underlying asset in a certain direction. For example, assume that Jim was holding a position in stock between March and November and that he was expecting the value of the shares to increase.

Let’s imagine that Jim notices that the price fails to get above $39 several times over several months, even though it has gotten very close to moving above that level. In this case, traders would call the price level near $39 a level of resistance. As you can see from the chart below, resistance levels are also regarded as a ceiling because these price levels represent areas where a rally runs out of gas.

Support levels are on the other side of the coin. Support refers to prices on a chart that tend to act as a floor by preventing the price of an asset from being pushed downward. As you can see from the chart below, the ability to identify a level of support can also coincide with a buying opportunity because this is generally the area where market participants see value and start to push prices higher again.

Trendlines

The examples above show a constant level prevents an asset’s price from moving higher or lower. This static barrier is one of the most popular forms of support/resistance, but the price of financial assets generally trends upward or downward, so it is not uncommon to see these price barriers change over time. This is why the concepts of trending and trendlines are important when learning about support and resistance.

When the market is trending to the upside, resistance levels are formed as the price action slows and starts to move back toward the trendline. This occurs as a result of profit-taking or near-term uncertainty for a particular issue or sector. The resulting price action undergoes a “plateau” effect, or a slight drop-off in stock price, creating a short-term top.

Many traders will pay close attention to the price of a security as it falls toward the broader support of the trendline because, historically, this has been an area that has prevented the price of the asset from moving substantially lower. For example, as you can see from the Newmont Mining Corp (NEM) chart below, a trendline can provide support for an asset for several years. In this case, notice how the trendline propped up the price of Newmont’s shares for an extended period of time.

On the other hand, when the market is trending to the downside, traders will watch for a series of declining peaks and will attempt to connect these peaks together with a trendline. When the price approaches the trendline, most traders will watch for the asset to encounter selling pressure and may consider entering a short position because this is an area that has pushed the price downward in the past.

The support/resistance of an identified level, whether discovered with a trendline or through any other method, is deemed to be stronger the more times that the price has historically been unable to move beyond it. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit points because these areas often represent the prices that are the most influential to an asset’s direction. Most traders are confident at these levels in the underlying value of the asset, so the volume generally increases more than usual, making it much more difficult for traders to continue driving the price higher or lower.

Unlike the rational economic actors portrayed by financial models, real human traders and investors are emotional, make cognitive errors, and fall back on heuristics or shortcuts. If people were rational, support and resistance levels wouldn’t work in practice!

Round Numbers

Another common characteristic of support/resistance is that an asset’s price may have a difficult time moving beyond a round number, such as $50 or $100 per share. Most inexperienced traders tend to buy or sell assets when the price is at a whole number because they are more likely to feel that a stock is fairly valued at such levels. Most target prices or stop orders set by either retail investors or large investment banks are placed at round price levels rather than at prices such as $50.06. Because so many orders are placed at the same level, these round numbers tend to act as strong price barriers. If all the clients of an investment bank put in sell orders at a suggested target of, for example, $55, it would take an extreme number of purchases to absorb these sales and, therefore, a level of resistance would be created.

Moving Averages

Most technical traders incorporate the power of various technical indicators, such as moving averages, to aid in predicting future short-term momentum, but these traders never fully realize the ability these tools have for identifying levels of support and resistance. As you can see from the chart below, a moving average is a constantly changing line that smooths out past price data while also allowing the trader to identify support and resistance. Notice how the price of the asset finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down.

Traders can use moving averages in a variety of ways, such as to anticipate moves to the upside when price lines cross above a key moving average, or to exit trades when the price drops below a moving average. Regardless of how the moving average is used, it often creates “automatic” support and resistance levels. Most traders will experiment with different time periods in their moving averages so that they can find the one that works best for this specific task.

Other Indicators

In technical analysis, many indicators have been developed to identify barriers to future price action. These indicators seem complicated at first, and it often takes practice and experience to use them effectively. Regardless of an indicator’s complexity, however, the interpretation of the identified barrier should be consistent to those achieved through simpler methods.

The “golden ratio” used in the Fibonacci sequence, and also observed repeatedly in nature and social structure.

For example, the Fibonacci retracement tool is a favorite among many short-term traders because it clearly identifies levels of potential support/resistance. The reasoning behind how this indicator calculates the various levels of support and resistance is beyond the scope of this article, but notice in Figure 5 how the identified levels (dotted lines) are barriers to the short-term direction of the price.

Measuring the Significance of Zones

Remember how we used the terms “floor” for support and “ceiling” for resistance? Continuing the house analogy, the security can be viewed as a rubber ball that bounces in a room will hit the floor (support) and then rebound off the ceiling (resistance). A ball that continues to bounce between the floor and the ceiling is similar to a trading instrument that is experiencing price consolidation between support and resistance zones.

Now imagine that the ball, in mid-flight, changes to a bowling ball. This extra force, if applied on the way up, will push the ball through the resistance level; on the way down, it will push the ball through the support level. Either way, extra force, or enthusiasm from either the bulls or bears, is needed to break through the support or resistance.

A previous support level will sometimes become a resistance level when the price attempts to move back up, and conversely, a resistance level will become a support level as the price temporarily falls back.

Price charts allow traders and investors to visually identify areas of support and resistance, and they give clues regarding the significance of these price levels. More specifically, they look at:

Number of Touches

The more times the price tests a support or resistance area, the more significant the level becomes. When prices keep bouncing off a support or resistance level, more buyers and sellers notice and will base trading decisions on these levels.

Preceding Price Move

Support and resistance zones are likely to be more significant when they are preceded by steep advances or declines. For example, a fast, steep advance or uptrend will be met with more competition and enthusiasm and may be halted by a more significant resistance level than a slow, steady advance. A slow advance may not attract as much attention. This is a good example of how market psychology drives technical indicators.

Volume at Certain Price Levels

The more buying and selling that has occurred at a particular price level, the stronger the support or resistance level is likely to be. This is because traders and investors remember these price levels and are apt to use them again. When strong activity occurs on high volume and the price drops, a lot of selling will likely occur when price returns to that level, since people are far more comfortable closing out a trade at the breakeven point rather than at a loss.

Support and resistance zones become more significant if the levels have been tested regularly over an extended period of time.

The Bottom Line

Support and resistance levels are one of the key concepts used by technical analysts and form the basis of a wide variety of technical analysis tools. The basics of support and resistance consist of a support level, which can be thought of as the floor under trading prices, and a resistance level, which can be thought of as the ceiling. Prices fall and test the support level, which will either “hold,” and the price will bounce back up, or the support level will be violated, and the price will drop through the support and likely continue lower to the next support level.

While spotting support and resistance levels on a chart is relatively straightforward, some investors dismiss them entirely because the levels are based on past price moves, offering no real information about what will happen in the future.

Determining future levels of support can drastically improve the returns of a short-term investing strategy because it gives traders an accurate picture of what price levels should prop up the price of a given security in the event of a correction. Conversely, foreseeing a level of resistance can be advantageous because this is a price level that could potentially harm a long position, signifying an area where investors have a high willingness to sell the security. As mentioned above, there are several different methods to choose when looking to identify support/resistance, but regardless of the method, the interpretation remains the same—it prevents the price of an underlying asset from moving in a certain direction.

The Psychology of Support and Resistance Zones

Technical analysts use support and resistance levels to identify price points on a chart where the probabilities favor a pause, or reversal, of a prevailing trend. Support occurs where a downtrend is expected to pause, due to a concentration of demand. Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply. The article “Interpreting Support and Resistance Zones” examines the basics of this technical analysis tool. This story will examine how support and resistance zones are largely shaped by human emotion and psychology. (Every time an investor talks about getting in low or picking entry and exit points, they are paying homage to these men. See The Pioneers of Technical Analysis.)

The Psychology of Support and Resistance

In a given financial market, there are typically three types of participants, at any given price level:

  • Traders who are long and waiting for the price to rise
  • Traders who are short and hoping the price will fall
  • Traders who have not decided which way to trade

As the price rises from a support level, the traders who are long are happy and may consider adding to their positions if the price drops back down to the same support level. The traders who are short in this situation are beginning to question their positions and may buy to cover (exit the position) to get out at, or near, breakeven if the price reaches the support level again. The traders who did not enter the market previously at this price level may be ready to pounce and go long if the price comes back down to the support level. In essence, a large number of traders may be eagerly waiting to buy at this level, adding to its strength as an area of support. If all these participants do buy at this level, the price will likely rebound from the support once again.

Price can, however, fall right through the support level. As price continues to drop, traders will quickly realize that the support level is not holding. The long traders may wait for the price to climb back up to the previous support level, which will now act as resistance, to exit their trades in the hopes of limiting their losses. The short traders are now happy and may consider adding to their positions if price revisits the price level. Lastly, the traders who did not enter the market yet may go short if the price comes back to the previous support level, in anticipation of price dropping further. Again, a large number of traders may be ready to make a move at this level, but now instead of buying, they will be selling. This same behavior can be witnessed in reverse with traders’ reactions to resistance levels.

Shifting Zones

These examples illustrate an important technical analysis principle: That which previously acted as support will eventually become resistant. Conversely, levels that formed resistance will act as support, once price breaks above the resistance level. This can be seen on any chart or any time frame. Though investors commonly refer to daily charts to determine areas of support and resistance, smaller time frames are also used, especially by short-term traders, to establish these areas. Figure 1, for example, shows a 15-minute price chart of Coca-Cola (NYSE:KO). The yellow line represents a price level ($67.60) that has flip-flopped between acting as resistance and support, and back to resistance.

Support and resistance zones are not only seen at particular prices; they can exist along with up or down trendlines. Figure 2, which shows a two-year daily chart of Johnson & Johnson (NYSE:JNJ), illustrates how these zones can appear as horizontal lines (the support in this example) or with prices that occur along a trendline (the resistance level in the chart). Time and again, over the course of two years, these levels were tested, breaking significantly above or below the trendlines only twice. (We’ll show you which candles shed light on successful trend trades. Check out Inside Day Bollinger Band® Turn Trade.)

Human Emotions and Behavior

Fear, greed, and herd instinct are terms that often come up when discussing the financial markets. This is because human emotions and behavior are largely responsible for price movements in the markets. A price chart, then, can be thought of as a graphical representation of emotions such as fear, greed, optimism and pessimism, and human behavior, such as herd instinct. Price charts illustrate how market participants react to future expectations. (Find out how your mindset can play a larger role in your success than market influences. Check out Trading Psychology and Discipline.)

Fear and greed, for example, are seen in the market participants’ behavior outlined above. As price falls back to a support level, the traders who are already long will add to positions to make more money. Meanwhile, the traders who are short will buy to cover, because they are afraid of losing money. Herd instinct is also demonstrated in this example as traders tend to congregate near these support and resistance levels, further strengthening them.

Traders can also collectively experience a conditioned response, of sorts. Figure 3, which shows a daily chart of Eli Lilly (NYSE:LLY), shows how two previous price peaks formed resistance that reflects a significant uptrend. Traders who studied this chart and drew a trendline connecting the two price peaks that occurred in early August and mid-October of 2020 would have expected resistance once price finally reached the trendline’s projected path. Indeed, this is what happened back in April 2020, as price met the trendline’s path. Similarly, traders might expect to see support again when the price drops down near $33.50, since that price level provided strong support on at least three previous occasions.

Figure 4 further demonstrates this concept, as the price is drawn like a magnet to the trendline on a daily Berkshire Hathaway chart (NYSE:BRK.B). In this case, a down trendline acts repeatedly as resistance over the course of six months. Once the price is successful in breaking above the trendline, the line forms significant support over the next several months.

Emotional Price Levels

Other support and resistance levels that are influenced by human emotion include round numbers (since they are easy to remember), 52-week highs and lows, and historic events such as new market highs. Traders and investors tend to gravitate to these psychological price levels for several reasons. One is that these prices have been significant in the past and traders know they are likely to be again. Market participants often gauge future expectations based on what has happened in the past; if a support level worked in the past, the trader may assume that it will provide solid support again.

Another reason that emotional price levels are significant is they attract a lot of attention and create anticipation, which can lead to increased volume as more traders get ready to respond. New market highs, for example, create a buzz of excitement as traders imagine price going higher, with no previous resistance levels to slow it down. As the bulls take charge, the euphoria can result in a significant push above the previous high, typically with increased market participation, until the enthusiasm wanes and a new resistance level is established.

The Bottom Line

Support and resistance zones are utilized by technical analysts to study past prices and predict future market moves. These zones can be drawn using simple technical analysis tools, like horizontal lines or up/down trendlines, or by applying more advanced indicators, such as Fibonacci retracements. Market psychology plays a major role in a given instrument’s price movement as traders and investors remember the past, react to changing conditions and anticipate future market movement. (Knowing what the market is thinking is the best way to determine what it will do next. To learn more, refer to Gauging Major Turns With Psychology.)

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