Part of the problem with how people use support and resistance is that although most are aware of the different basic ways a market can respond to a technical level, they often are not taking it into account when executing around a level.
A market does not have to instantly bounce from a level and this is a dangerous way of thinking that’s easy to get sucked into.
A market can breach a level only to turn around and reverse back where it came from.
A technical level of support and resistance is merely a reference point for subsequent activity and this must be at the forefront of a trader’s mind when looking for clues to take their next trade.
I’m not going to cover how to identify what a decent level looks like in this post as I’ve covered it elsewhere.
Before we get onto how a market can respond to a level, it’s absolutely crucial to cover rotations. A rotation is simply a definable leg within the market movement.
It doesn’t have to be a big directional swing – think of it in terms of breathing. A market must, just as a living creature, breath in and out. In a bigger directional move, there are still counter rotations to the move. You can think of these in terms of breathing out – the expulsion of stale air or market energy in readying for the next intake of breath to fuel the next rotation in the direction of the bigger move.
The key point is that it’s always happening and by identifying the size of the last swing, you can get a better feel for whether enough energy has been expended in order to encourage the other side to push the market in the opposite direction – at least by enough for what you consider to be a small rotation.
Now of course, the size and distribution of rotations is highly dependent on the product and the timeframe that you are looking at. To extract this kind of information from the market you are looking to trade is far easier if you have the kind of software to do most of the work for you. If not, you can select a period and do it manually. What you’ll end up with is a distribution and what has been the most common sized rotation over the period of analysis.
By tailoring the timeframe you trade and the general scaleout size to take the market’s rotation profile into account, you can get to a point where your trades have a much greater probability of becoming “safe” even if they don’t end up being big winners.
Put another way, understanding rotations can help you get in sync with the market flow.
Basic ways a market can react to Support and Resistance
Okay so now we have some basics about rotations as a foundation, let’s look at the ways the market can react to levels of support and resistance.
First of all, it can bounce from or a tick or two before the level itself.
Like in all cases, a market can bounce with a counter rotation of sufficient size. However, before the counter rotation is sufficient in size, it looks like this:
At this point, the market can continue up and form a reasonable bounce or it can continue to move lower but at the same time be moving back and forth by a handful of ticks each time it does.
At this point, it’s a little bit premature to make assumptions based on the information the market is giving you.
Once the market has moved a full rotation however, the chances of it pulling back to the level and then at least attempting a secondary push in the same direction, are much higher.
The second basic way a market can react to a support and resistance level is by scything through it.
Again, for a greater chance of the break to at least have a secondary push after pulling back to or somewhere towards the level, the simple requirement is that the break is by a number of ticks that by studying the market, has been identified as a common size for a rotation.
The last basic way and the one that often catches people out, is that the market can breach a level by a small number of ticks and only then begin to reverse.
Now there are of course many different combinations that the markets can conjure up to throw us off course. Indeed, the market does not have to do anything. But we’re not expecting certainty are we. All we’re after is a decent probability to lean on.
Timing is key
A market can look like it has already reacted to a level in a certain way. It might look like it’s bounced for example, only to run through the level on a retest. It might look like it’s broken the level but really it’s trapping sellers (in the examples I’ve used). The key thing here is to get your timing right and to do this you can leverage your understanding of rotations.
If a market bounces from or breaks through a level by a decent number of ticks, what it’s telling you is that it had enough energy on that side to gain that reaction and at least an additional secondary test in that direction is therefore likely after any pullback. It might continue to reverse or power on lower. In fact it might never give you a decent pullback at all once you’ve spotted how it’s initially behaving.
But until you see how the market reacts, it’s extremely difficult to judge the nature of other traders and what they want to do at the level.
I will always believe in the importance of identifying key technical levels of support and resistance. However, without considering how a market can react once it gets there, you are at risk of making an error in assuming it will do one thing or the other – either bouncing after pulling back from the level by just a handful of ticks or making a big move on a breakout just because the price is traded through by a tick or two. Understanding rotations and market energy is another part of unlocking the power of levels.
Get it right and you’ll potentially improve your timing of trades significantly.
For more updates from Mark and the team at NetPicks, be sure to visit their trading tips blog at NetPicks.com.