The Psychology of Support / Resistance

Hey everybody,

I haven't been posting in a while because I was busy with exams, but I am back now--so back to the factory

John Murpy's and Alexander Elder's talk about price action and psychology really got me thinking and I THINK that I have experienced the aha! moment!

Here is my spin on the story:

Every market is a zero sum gain market. For one winner, there HAS to be one loser. In forex, currencies move in pairs - as one currency goes up another HAS to come down. Thus, when two people are trading EUR/USD for example, as person who is long on EUR is winning, a person who is long on USD is losing.

There are 3 types of people who participate in any financial market at any given price level:

1. People who went LONG at that price
2. People who went SHORT at that price
3. And people who decided not to trade at that price.

Here is what happens when those 3 people encounter a currency (or a stock or future) penetrating an important Resistance level (R1).

As we all know, penetrated resistance (R1) automatically becomes support (S1). When that resistance is penetrated (few points above the actual resistance level), 3 things happen:

1. The bulls go LONG, thinking that a breakout is happening.
2. The bears go SHORT, thinking that the currency will retrace back under the resistance R1 (or below support S1)
3. Some traders do not know what to do, so they simply stay out.

The next day, our currency rises 20 more pips.

1. The bulls are biting their elbows because they did not buy more lots, and are hoping for a retracement abck to support to buy more
2. The bears are biting their elbows because they are obviously are on the other side of the market and are waiting for a retracement back to support S1 to close out their SHORT positions and B/E.
3. The bystanders are biting their elbows because they missed out a rally, and are waiting for retracement back to support S1 to go LONG.

Because of that, all 3 groups of the market (the WHOLE market) are going to go LONG if the price retraces back to S1. This tests the importance of that new support S1. At support, everyone goes long, driving the price up. The longer the currency stays at support, the more valid or important that support is. The high spike in volume will tell us that a breakout is imminent.

Same story goes for broke support levels. Just change the word LONG to SHORT and the word SHORT to LONG.

Double tops and double bottoms also operate on the same principle.

Any comments and thoughts are appreciated!

Good trading,

Roman

I think you missed out something..

Now here is the scenario once again: Price breaks R1 and the level becomes S1, here are the 3 types of people just at the breakout:

1- Bulls who entered long at the breakout to profit from the rally
2- Bears who are speculating that the breakout will be fake and will eventually become a bull trap
3- Sideliners who do nothing and don't open a position

Now, the curreny rallies 20 or 30 pips, and here are the 3 types of people once again:

1- Bulls who are closing their positions for a profit, bulls who are closing part of their position for a profit and waiting for further profits and bulls who refuse to close any part of their position and wait for more

2- Bears who are holding a losing trade right now and closing their position with a loss, bears who are closing half their position for a loss and wait for the next half to be closed at a better price or BE and bears who hold on with their position hoping that they will be able to close at BE or a small profit in a while

3- Sideliners who are entering long after the rally because they don't want to miss the big move, Sideliners who are thinking that the currency is getting ahead of itself and takes the decision to short it actually and Sideliners who decide to remain sideliners

So as you can see from this scenario you are looking at it from a little different prespective, Sideliners almost neutralize each other, while bulls selling are more than bears covering (This is how the breakout actually happened, bulls were buying more than bears were shorting), so the currency pulls back to S1 as more bulls are selling for profits and less bears are covering for losses.

Now we actually returned back to the point of S1 where almost all bulls who were selling finished selling and all bears who are covering finished covering, so there is actually no one left to buy to push the currency above S1 and also there are no more bears to sell to push down below S1. Unless new buyers come into the market and start buying or new bears come into and start shorting at this S1 level, we won't see any confirmation. Here comes the major of the remaining sideliners who decided to be neutral for 2 consecutive times, if they decide that this move is a real breakout and make their minds to buy, then we'll see a bounce off the S1 level and continue the rally as more shorts will cover their shorts while we go up and more bulls will buy to add to their winning positions, and if the sideliners decide it was a fakeout, they will short the market and bulls will sell and shorts will short once again and thus we see another breakout to the downside and it's a bull trap.

What I want to say is that it needs more money to flow into the market after a breakout to confirm the market in a certain direction..What you have mentioned that everyone is gonna buy when we go back to S1 is not totally correct, people don't act the same all the way and under the same conditions, you must have different people with different opinions and visions even if they all hold the same position in the market, and this alone is a great complication in the trading psychology.

Any comments???


Thanks,

Nader

That actually makes a lot of sense...I thought that I would be missing something or not getting something

ok guys, nice frameworks.

one thing i see differently is that "bulls" are already long when the price breaks R1. see attached for john murphy's view of support and resistance...i too have adopted this train of thought....

btw, gcl915, not all markets are zero sum, only commodity markets (and currencies are a commodity). for instance, if a stock rallies, all of the shareholders will profit without anyone having to lose anything. there is not a seller for every buyer. the "seller" of the stock is the company itself, and the company surely doesnt lose when it's stock rises.

pg2

pg3

btw, i read this years ago, and i remember it took me 5 or 6 times of reading it before i fully understood what murphy is saying. the basic take away is that the more buying and selling that goes on at a certain price, the "stronger" that price tends to be, acting as a support or resistance.

Hi merlin, could you please tell me what book you got these excerpts from?
Are they from John Murphy's "somethin somethin... Financial Markets"?


Thanks..

"Technical Analysis of the FInancial Markets"?

yup! can you believe i read that beast of a book?

Almost, but not quite. The only markets that are zero sum are the ones that start at zero and end at zero. These are futures and options markets that have a set expiry date. Spot FX is not zero sum. AUD/USD could go up and up and up forever.

Although, theoretically, even zero sum games are negative sum because of spread and commissions but that is another story.

Simon

lol..

Thanks Merlin.. It's the next book I'm planning to purchase..
And hopefully I can also finish reading such beast of a book..

Ahh looks like I have some re-reading to do. I have the book as an e-book and 500+ pages are "fun" to print.

it most certainly is a zero sum market. all commodities are zero sum, and currency is a commodity. equities are the only non-zero-sum markets.

As long as there is a buyer for every seller or more or vice versa, the game is a zero sum...The AUD/USD can go up and up and up but not forever, nothing goes up forever or goes down forever....

I agree with Merlin that the stock market is not a zero sum game because the price can go up and still all the shareholders don't sell, so people who actually don't own shares are bidding the stock up...Stocks pay divedends as well, so this is not a zero sum as these divedends flow into the market from outside, from the company itself to the pockets of shareholders, that's a profit, but without a buy or a sell order being actually processed...

Investing is not a zero sum game, trading is...Companies values change because there are assets, liabilities and shareholders' equity there...They are actually real assets behind the stock...Futures and currencies are not backed up by actual real assets..Yes a future contract represent a certain amount of a commodity to be bought or sold at the delivery date, but it's the spot value of this certain asset which determines the value of the future contract...And it is also missleading to call commodities as assets, they are not...Most commodities are consumables, corn, bean, soybean, cotton, oil, etc, so we can't call them assets as they depreciate and then dissappear all over...Even gold is not a complete asset...Gold depreciate and dissapear too, but the life cycle of this depreciation is very long...On the other hand, a company owning a piece of land can be called having an asset, owning a house can be called an asset, even inventory can be an asset..

What I actually want to say is that currencies trading is zero sum, forget the commissions and spreads, it's zero sum...Stocks are not....That's all...


Thanks,

Nader