I am new to trading so please pardon my ignorance.
I have asked this question several times but never really got a convincing answer. What really happens at a support price such that price tends to bounce from it and vice versa for resistance? If i understand correctly....every buy has an equal and opposite sell. So at the support price there is equal amount of selling and buying, but people say price will go up as lot of buying is happening.
If this question has already been answered please guide me to that thread.
So you mean that price can move on zero volume or no transactions at all. Lets say there is only one buyer and one seller. The buyer says he is willing to pay $10, but seller want more. Buyer raises the price to $11, but the seller still wants more. Buyer moves to $12 and at this price the seller actually sells. So the price moved from $10 to $12 without any transaction. the chart for this will show zero volume and transactions from $10 to $12. Is this assumption correct?
Basically, you seem to be asking why support and resistance levels work. There are a number of reasons why this happens, all of which have to do with psychological principles of human behavior.
Support and resistance levels are formed where a lot of trades occurred in the past. Think about what this means - it means that at or around this level, a LOT of people made bets on the direction that a particular instrument was going to go.
How would you feel if you bought some shares in a stock at let's say $40, thinking that it was going to go up to $50, but instead it started drifting down? So you buy at $40, but the next day the price goes down to $39. You think, "no big deal, just a small drop, it will come back". The next day it falls some more to $37. Now you start to get worried - you think "Uh oh, this isn't going the way I thought... but I can't sell now, because that would be like admitting I was wrong, and it's not a loss until you sell, right? Maybe it will come back!".
The next day it opens up at $34.50. "Crap!!" you think, "I KNEW I should have sold yesterday! Why, oh why did I listen to my broker who gave me this tip - what an idiot! Man, I will be lucky if it just gets back to break-even! Please, please, please just let it go back up to where I bought, I PROMISE if you just let me out of this bad position, I will never take another stock tip again! Just let me get back to break-even!".
So you hold and hold this thing, and eventually after a couple of days it starts to rise. $35. $36. $37. $38.50. Finally, on one magical glorious day, it rises back to $40 where you bought it. What would you do now? After having been through that emotional roller coaster seeing it go down and then back up, do you really want to keep holding this thing? Or do you want to just get out and thank your lucky stars that you didn't actually lose anything? Most people would sell in this scenario just to get themselves "emotionally relieved", and they do. They had such a bad experience holding this thing, that the first opportunity that they have to get out without taking a painful loss, they take it.
Now when you get an area of price where a LOT of people made bets on a particular direction and were proven wrong, those same people are going to get out when the price retraces there because they don't want to go through the emotional pain of watching it go the wrong way again. This is the primary factor that creates resistance and support levels.
A second factor is all the people who were initially watching that thing and thinking that they should go short the first time at $40. As they watch it drop in the scenario I outlined above, they think to themselves, "Crap! I KNEW I should have shorted that thing when I had the chance! If it comes back to that level I'll get in!". When they do see it come back up, they remember the emotion they felt at missing out on the first trade, so they quickly establish short positions which helps to stall the price. This also works in reverse when a stock goes up and then comes back down to support where a lot of people who didn't get in the first time see it as a second chance at a buying opportunity. Those people getting in helps to stop the fall in prices.
Thirdly, imagine that you were a person who did actually establish a successful short position the first time around at $40. Imagine that you saw it fall to $35 and then covered for a profit. Remembering that positive experience, when the price got back to $40 again, what would you do? You would establish another short and try to do it again, wouldn't you? Those people also help to serve as resistance.
Fourthly, what if you established a short position, watched it fall to $35, never got out, and then watched your profit erode as it rose back up to $40. What would you do here? Many people would try to double down because they couldn't stand the psychological loss of admitting that they had just missed out on some profits, so they would get even more short to "get back" at the market which just took away their nice little gain. Those people also help to cap the price.
Finally, because support and resistance areas are well known, a lot of traders in general look at them. Because so many traders think that these levels are going to stop the price, they will place bets there in anticipation of that, which ironically becomes a self-fulfilling prophecy and actually makes it happen.
Basically, price levels have "memory", because human beings are not computers, and because they act on emotion 99% of the time. Human beings will act very differently at a break-even point than they will when they are in a profit or loss position, so any area of price where a lot of people placed bets (i.e. trades) is going to contain a lot of "emotional energy" for that reason. That is what helps to slow price movement and creates resistance and support areas.
You will note that in a trend, price movement will often gap or spike through these levels. That is because in order to keep a trend going, you have to "blow through" these levels fairly quickly, before the people who bought/sold there have time to get emotionally aware that they are at "break-even". If you approach a price level and then "blow through" it, you are instantly going to turn a bunch of people who were in losing positions back into people who are now in winning positions. This will radically change their mentality and will cause them to NOT get out of their positions. In many cases, they may even add more shares/contracts in the trend direction as now they are feeling elated. Similarly, blowing through a price level is going to panic a lot of people who were previously in a profit position before the "blow through" happened, and are now all of a sudden sitting on a loss that is rising. Those people will tend to get out in a hurry, causing the price trend to continue. This is all part of a necessary psychological mechanism that keeps trends going as one support/resistance level after another is broken in rapid succession. If price ever stalls for a long time at resistance or support, that's when it's more likely to reverse as the "break-even" mentality has time to take hold, as described above.
So, that's why resistance and support levels work - because a chart is really nothing more than a map of human behavior, and these areas indicate price levels where there is a lot of trapped emotional energy that affects trading.
Last edited by FBJS; January 12th, 2010 at 11:20 PM.
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I read your post twice and will read it again tomorrow morning so that the idea really sinks in. One thing left unanswered is; does every buy order has an equal opposite sell order? This is the only way i see a transaction happening. Is my thinking correct or am I missing something?
I also happened to notice that you are from Toronto. I have lived a major portion of my life in Toronto as well....Scarborough to be exact. Good to see a fellow Canadian here.
Hey Tony... yep, I have to say it's good to be Canadian in these times... our economy has certainly held up better than most over the past year!
Regarding your question, it's not that every buy order has an opposite sell order, it's that every share/contract being sold has someone willing to buy it. (The orders themselves don't match exactly.)
A transaction is defined as a price where a buyer and seller have both temporarily agreed on the value of something. The buyer has agreed to pay X, and the seller has agreed to sell for X, at that moment in time.
However, the market is not made up of a single transaction, it is a series of transactions over time. Suppose you have a buyer who really, really needs (or wants) to buy a lot of a certain thing. Suppose this buyer manages to find a seller who agrees to sell him some of this thing at a certain price, let's call that price "X". So the seller says "I have this much available at this price", and the buyer says "No problem, I'll take it!". After this transaction is completed, the buyer then says "How much more have ya got, I really could use more of this stuff!". Now, if you were the seller, what would you say? Assuming you did actually have more of whatever this stuff is available in your warehouse, would you agree to sell more of it to the buyer at the same price? Or would you say "No problem, but if you want more, it's going to cost you a bit extra - 10% higher prices for the next batch!". You would do this because the way that the buyer just jumped at your first offer and took everything you had to sell would tell you that he was desperate. You would raise the price to see just how much more you could get for the next lot, right?
Now let's suppose that the buyer is desperate or greedy, and let's suppose that he's not sure where else he's going to find more of this stuff that he needs. So he agrees to the seller's terms and says "Sure! I'll take that deal, sell me some more even if it costs me 10% extra!". In this case, another transaction happens, only at a higher price. But the buyer is still not done, he needs more. So he says "How much more have you got?" The seller sees that this guy is REALLY desperate, and he knows that through his cousin Leo he can acquire even more of this thing - so he says "Sure, I can get ya more, but this time it will cost you an extra 30%!".
Now, at this point the buyer pauses. He has already bought some of what he wanted, and he would buy more if the seller was willing to let it go for cheaper, but his need is not quite as dire any more, and besides, 30% higher is a bit of a rip-off. So instead of taking it, he counters with another offer: "I'll tell you what, I'll take some more off your hands, but I'll only pay an extra 20% for it, what do you say?".
The seller pauses at this point. He stops, he thinks about it. Then he says, "Sure, why not?". And a new trade happens.
Now, replace a single buyer in this case with a lot of individual buyers acting as a group and bidding against one another. And replace the single seller with a lot of individual sellers acting as a group. The bid/ask represents the best price being offered by each side, and when an individual from one side really wants to buy/sell, they need to cross the market and execute their trade at the bid/ask if they want a trade to happen. In our example above, the buyer was taking (buying) supply at the offer all the way up, UNTIL the seller asked for a price that was too high. He then countered with a bid that was slightly lower, and the seller, because the prices were already a lot higher than he thought he was going to get in the first place, and because there were no other buyers jumping at whatever he was selling, was motivated to "cross the market" and "hit the bid", meeting the buyer's counter-offer at 20% higher.
This type of thing happens all the time, very quickly, with many transactions being conducted by many individuals, and that's how the market moves. For every buyer there is obviously always a seller, but that in and of itself is irrelevant. The only thing that matters is the psychological trending of price as this entire group of people collectively agrees moment to moment about which way the price is heading. Because buyers are competing with other buyers and sellers are competing with other sellers for the same stuff, they are constantly placing their orders to get ahead of the other guys on their "side", and in many cases are crossing the market and taking out bids/offers in order to do so... the same way that our buyer in the example above was desperate enough to keep paying higher prices and buying "at the ask", even though the "ask" kept rising.
In a trading scenario, when a bid is hit and someone sells some stock, that will drop the price. This will cause would-be buyers to be that much more reluctant to buy this thing which appears to now be dropping a bit, so they may pull some of their bids and be more reluctant to cross the market to buy at the ask. They are waiting to see what happens, because they don't want to be stuck in a position at a high price if this thing is starting to drop.
This hesitation on the part of the buying side causes one seller to get nervous, so they decide to hit the bid (sell) some more, before someone else on their side gets that same bright idea and takes out whatever the current bid is before they can. If that happens, then the seller in question is going to have to sell for even lower prices if they want to get out, because whatever the current bid is will be gone.
Now let's say a few more sellers do hit the bid and the price drops some more. The buyers are now REALLY nervous about buying more at this point because the price is obviously dropping - so even less of them are willing show up with bids. Why pay more for something now if it's going to be lower in 5 minutes, right?
So the price sits there for a short while, and still more sellers emerge because their side is getting more and more nervous. As each new seller comes in to hit the ever-dropping bid the price continues to fall, and buyers are less and less willing to buy - until it finally reaches a level where someone on the buy side decides to step in and absorb the selling.
When that happens, the price will pause while trades occur at the final lower price. Sellers are still selling at this point, but the buyers as a group are pretty happy with this new lower price and are willing to step in and buy whatever the sellers are throwing at the market at these levels. They are now skeptical that it's going to drop much further, so they start competing with one another to get whatever they can at these new cheaper prices. Whatever selling pressure there is starts to be met by equal or greater buying pressure as more and more bids get placed and more and more buyers start buying whatever the sellers are offering at the ask.
The psychology of everyone now starts to reverse in the other direction. The price starts rising again as the sellers have tapped themselves out and buyers get more and more anxious about competing with one another, since they have to now start paying higher and higher prices to get in. Any would-be sellers are reluctant at this point to get rid of what they have, since the price is currently rising and they want to see how far it can go... so they hold off on hitting the bid or placing new offers, and that makes less supply available for would-be buyers, which causes them to chase the market even higher if they want to own this stock. This new trend continues until we reach a price where the buyers are reluctant to keep buying so enthusiastically at higher prices, and the sellers start getting worried about the market dropping back down. The cycle then just repeats itself by going back to the beginning.
This mechanism is how price rises and falls - it is just a psychological shift on the part of every participant in the market as they try to compete with each other for a limited supply of something, mostly driven by fear of either missing out on a winning trade or fear of taking a loss.
Last edited by FBJS; January 13th, 2010 at 02:16 AM.
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No problems... yeah, we definitely held up better because our economy was never as red-hot as the US, and our lending standards were a heck of a lot stricter. Every single one of our major banks is in better shape than even the strongest US institution, last time I checked. (I think that all are in the top 30 or so in the world.)
I remember being in Illinois a few years back and driving thorough suburbia... I was absolutely amazed at how many strip malls there were... every single corner had a large mall complex full of stores on literally every block, mile after mile after mile... I remember thinking, "How the heck can the economy support all these stores? Who in the world could possibly afford to do this much shopping?". Well, now we know! You know when your bank has to build five drive-through lanes to accommodate all the people coming by every day, that maybe your lending standards are just a little bit too loose...
Royal Bank #10
Bank of Montreal #33
The only US banks listed were Wells Fargo at #21, US Bancorp at #26, Bank of New York Mellon at #35, and JP Morgan Chase at #47. So I guess I was a little off with my numbers, but still pretty close... it was a while since I had looked at it...
Last edited by FBJS; January 13th, 2010 at 03:05 PM.