Why do support and resistance lines work in stock trading?
Support and resistance works because of market participants’ actions and expectations. Charts, chart features like support and resistance are windows into market participants’ mass psychology. Case study.
The man who had stock levels in his head
I recall this ex-colleague of mine who was an enthusiastic stock market speculator. He read the newspaper everyday and zoomed into the stock column. He ‘specialised’ in a handful of stocks and one of his favourite was an airline counter.
Over a few years, he mastered the price movement of that airline pretty well. It was all in his head.
This gentleman told me:
“Buy XYZ when it falls to $9 and sell when it goes to $10. 8 out 10 times price will move that way.”
It’s true! I monitored for awhile and it turned out that he was right. In fact he was making a lot of money.
One day he came into office gloomy. As usual, he bought the airline stock at $9 but this time price did not move according to plan. In fact it fell very quickly to $8.00.
“What are you going to do?”
“I am going to sell the stock when price comes back to $9 so that I can break even.”
One another occasion, my dear colleague bought the same stock at $9 and took profit at $10. To his amazement, it went to $11! Although he tried to be discreet, he was in touch with his broker the whole day.
“So what will you do this time?”
“I don’t want to lose out on any price gain so I have already instructed my broker to place a buy order at $10. This was where I exited my previous position.”
Market participants act at familiar levels, actions reinforce those levels
My ex-colleague and his trading plan is an excellent case study. Markets are moved by people. People behave in ways they are comfortable with.
He, the airline stock speculator had a trading plan and his plan involved entering and exiting trade positions at levels that he was familiar and that familiarity was based on historical price movement that he observed and remembered.
- Stock market price movement is not ‘out of the blue’. A lot of movement is based on previously established levels.
- With or without charts, stock market participants like my colleague remember price levels. In their mind, these levels are associated with support and resistance.
- When price comes to these levels, these participants already have an expectation and will jump into action accordingly.
- My colleague bought airline stock at $9 and sold at $10. He associated $9 with support. He expected the stock stop at $9 and to subsequently go to $10. When he and a group of like-minded individuals jump in to buy, their collective action becomes a fulfilling force for their expectation. A large group of market participants buying at $9 and selling at $10 puts in a floor and ceiling for price at those levels.
- Even when price falls below $9 or rallies above $10, people like my colleague adjust their action but still centred around these levels. The old support price of $9 becomes a resistance because many place their exit orders there in order to exit at breakeven. The old resistance level of $10 becomes a support because many now place their re-entry orders there in order to ‘pretend’ they didn’t exit.
Support and resistance lines work because of our psychology
With charts, we can draw lines and make observations about price action. We can make very precise observations for support and resistance, for the number of times a support or resistance line were touched, for duration, for time frame and so on but fact is – it comes down to a big group of people deciding to buy or sell at a level they are familiar with.
More of technical analysis concepts like these are available in this free course material.