How Support and Resistance Areas are

Created
Written by Lance Beggs
How Support and Resistance Areas are Created

The following is some great email Q&A that occurred recently, which I'd like to share
with all readers...

Question:

Hi Lance,

In his text on support and resistance, Mike Reed talks about traders hoping the market will
return to a level of support or resistance so they can break even in that trade. So are levels of
support and resistance more to do with the behavior of traders than the actual value of the
dollar,

Thanks from Brian.

Answer:

Hi Brian,

Support and resistance are only about the behavior of traders - nothing else.

This is a big topic which won't be adequately addressed by a short email, but hopefully a
summary will make it sufficiently clear...

Price movement is a function of the balance or imbalance of supply and demand. This
supply/demand imbalance changes based on the sentiment of the market participants. More
bullish sentiment and price rises. More bearish sentiment and price falls. Support areas are
areas which have objectively shown an increase in bullish sentiment. We know this because
price rallied from that area. Resistance areas are areas which have objectively shown an
increase in bearish sentiment. We know this because price fell from that area. (See any
material by Sam Seiden on this topic - he teaches it better than anyone else I've read).

Now consider a trader conducting analysis on the market with the view to trading. What
creates the support and resistance areas are the heuristics and cognitive biases that are part
of human decision making. Of particular interest here is the anchoring bias. There's a whole
heap of others which influence our decision making, including the formation of support and
resistance, but this is the main one for s/r.

There is no absolute scale that can be used to determine the value of a tradable instrument.
Overpriced or underpriced is determined relative to previous price action. So, in the absence
of a scale, our mind needs to create a reference point (an anchor), which is a fixed point from
which it can then determine whether a security is overvalued or undervalued. The points that
stand out are the swing highs and lows, in particular those which create support or resistance
areas.

Consider a stock channeling between lower support and upper resistance. Prices towards the
lower end of the range are considered good value, because it's close to the anchor from
which price has previously rallied. As price gets higher though, it is perceived to be less of
good 'buy', as it is further from the good value area. And in fact as it approaches resistance,
it's not a good buy at all, because our mind sees it as being at an area (reference point /
anchor) which we've determined is overvalued, due to past evidence of price falling from that
point.

So, those in a trade in the long direction will be looking at the previous resistance area as an
opportunity to lighten their position, if not exit entirely. (That of course goes against the whole
idea of letting trades run, but there's other biases which make it 'human' for us to want to get
out of our winners rather than letting them run). Other traders will be looking to enter short at
the resistance. Both these actions, taken due to decisions influenced by the anchoring bias,
lead to the spt/res continuing to function in future.

Why does resistance, once broken, become support. The perception of value now changes.
The rally as price breaks through resistance is quite painful to those who went short, and took
a loss. It's even more painful to those who closed their long positions and missed the extra
profits. They now see this area as providing great value, and swear to the market Gods that if
price can just get back to that area they'll never be so stupid again. So when it drops back to
that new support area, these traders go Long.

Quick summary of a fairly advanced concept. Hope it helped bit.

You did mention price though, so I should point out one thing regarding price. Round numbers
can also be subject to the anchoring bias. For example, the difficulty in Gold getting over
$1000. It's such a psychological barrier - five figures seems much larger than four figures - so
we perceive anything over $1000 being overpriced, thereby creating resistance. This was
seen as well when the Dow spent years trying to break through 10,000 for the first time. It's
the same reason why products sell for $97 instead of $103.

Question:
Hi lance, I have now read your response to my question regarding support and resistance
several times and its really starting to make perfect sense. But lance, if s/r are man made,
and it now seems they are, why then do areas of s/r get penetrated. I mean what drives a
currency up through a resistance area? Cheers and thanking you for your help. from Brian

Answer:

Hey again,

What drives price through a support or resistance area? Changing sentiment, as the
information provided to the market changes. (NB. Changing sentiment refers to the resultant
sentiment of all market participants as a whole).

Remember, there are market participants trading (or investing) based on numerous different
analysis techniques, some of which (like the fundamental analysts) may have no idea where
chart-based support or resistance are at all. And they're also trading over different
timeframes. For example, someone trading on daily charts probably won't care where the 2
minute resistance is, unless it also coincides with the daily levels.

But regardless of the analysis methodology of the individual participants, the information
presented to the market is constantly updating, and something has changed to cause enough
of the participants to change their sentiment, allowing price to rally through resistance, or fall
through support.

It might be fundamental, such as a Fed report, or interest rate decision, which changes
people's future beliefs. It might be technical. For example, let's say a market is repeatedly
testing a resistance level, each time with a smaller and smaller retrace (ascending triangle),
many chartists will start to expect a failure of the level in the near future.

Markets are just people. Changes in price are simply the result of changes in sentiment of the
market as a whole. It's all about people and how they make decisions. Understand how other
traders will make their trading decisions and you will find an edge - because we're trading
against those other traders, not against the market.

Cheers,

Lance.