Support and Resistance

Support and resistance tells a technician what market participants think on a certain price level. Fundamentally, when a price’s level is low enough, market participants will buy the financial instrument at this support level. On the other hand, when the price level is high enough, market participants will sell the financial instrument.

An analogy is when a person enters a supermarket to buy shampoo, from this person’s experience, a reasonable price for the shampoo is about eight dollars. Now, what will happen if the supermarket puts on sale this shampoo for five dollars? All the shampoo users will buy even more then they usually buy, because they will never know when the price will rise again to the regular price they always experience. What will happen if the supermarket raises price to eight dollars? Most shampoo buyers will be neutral on buying. What will happen if the supermarket raises price again to $20.00? At this point surely most of this shampoo buyers will search for a different shampoo with more reasonable price and the same characteristics.

Recall the "experience" word in the analogy. Experience is when market participants acknowledge at certain price level a security is cheap and worth buying, or expensive and it will be wise to sell. Experience is also called memory; market participants have memory for prices and memory is related to the time frames I have mentioned. Major trend is the long-time market participant's memory, after comes the intermediate memory, and last short time memory. This memory establishes support, resistance, and trends, and as I have mentioned in the statistics chapter, prices tend to converge to the mean. This phenomenon is feasible because of market participants’ intermediate time memory; if prices move further away from its average, they will tend converge.

Traders use this phenomenon to enter trades, exit trades, or even plan strategies, especially options traders and scalpers they know that in a certain time in a day when a financial instrument drifts higher or lower than its daily standard deviation for scalpers and strategy planners it is to be an obviously a probable price convergence. Then it is time to sell at the close to pick or buy at the close to the low of day, and this is from the intraday point of view. A daily approach looks at the monthly standard deviation to distinguish price rise or decline above or below its monthly or yearly standard deviation. One exception is that a shorter time frame leads to more accurate results, a longer time frame is less accurate since more exogenous interruptions like economy news, press releases, earning reports are at stake and can influence price activity.