Support and resistance levels are ubiquitous in technical analysis, yet their 'realness' is a contentious topic among traders. Are they indeed real, or are they mere illusions created by human perception and market noise?
This debate is as old as the charts themselves. Some traders swear by these levels, while others dismiss them as nonsense. But before we delve into the specifics, let's first understand what support and resistance actually represent.
Understanding Support and Resistance
Support and resistance levels are areas on a chart where, historically, a security's price has struggled to break through, either from above (resistance) or below (support). These levels act as landmarks on the price chart, serving as potential reversal points.
In theory, when price approaches these levels, it should hesitate, retrace, or even reverse direction. This is because human psychology and market sentiment play a significant role in pricing, with participants' memories of previous price behavior conditioning their expectations and actions.
The Case for Reality: Technical Fundamentals
Proponents of real support and resistance argue that these levels are powerful tools due to their technical fundamentals. Price action is influenced by various factors, including order flow, supply and demand dynamics, and trading ranges. When price reaches these levels, it encounters clusters of pending orders, leading to increased trading volume and price action.
Moreover, these levels often correspond with previous peaks or troughs, which have strong psychological significance. Traders and investors remember these price levels and may act accordingly when price approaches them, creating a self-fulfilling prophecy.
Empirical Evidence
Numerous studies have shown that support and resistance levels can exert significant influence over price action. For instance, George Lane's famous study, "The Power of the Pivot," demonstrated that support and resistance levels (primarily the pivot point and its associated levels) were effective in forecasting price movements.
Similarly, various empirical tests on different assets and timeframes have revealed that support and resistance levels can indeed predict price reversals with a reasonable degree of accuracy. However, it's crucial to note that no system is infallible, and back-tests often underestimate the challenges of real-time trading.
Criticisms and Alternative Explanations
Despite the evidence in favor of real support and resistance, many traders remain skeptical. Some argue that these levels are not intrinsic to the market but merely a construct of our perception, created by our tendency to see patterns and Lao Tzu's 'well-trodden path.'
Others suggest that these levels are a result of after-the-fact analysis, where traders and analysts 'draw' lines to fit their narrative. This phenomenon, often referred to as 'chartism,' can lead to false discoveries and overfitting. Furthermore, critics point out that many 'real' support and resistance levels are broken with relative ease, and the supposed 'memory' of these levels fades swiftly.
Recency Bias and Adaptive Markets
Fans of behavioral finance argue that our reliance on support and resistance levels is a result of recency bias, where we overemphasize recent events and underestimate the market's adaptability. In their view, while these levels may hold some historical relevance, they lose their predictive power as market dynamics shift and evolve.
From this perspective, support and resistance levels are not 'real' but rather a vestige of the market's past. They exist only insofar as they are remembered and heeded by market participants. Once forgotten or ignored, they lose their potency and are replaced by new 'real' levels.
The Role of Human Psychology and Herding Behavior
Another line of criticism emphasizes the role of human psychology and herding behavior in creating the illusion of real support and resistance. When a significant number of traders recall and act upon these levels, they can indeed exert considerable influence over price action. However, their 'realness' is not inherent but rather a product of collective perception and behavior.
In this sense, support and resistance levels are not 'real' in an objective sense but rather reflect the subjective experiences and expectations of market participants. They are, in a word, social constructs, which can be powerful but are not immutable or 'reali