Explaining Stock Market using Behavioral Economics: Level of Resistance and Level of Support. Seriously, how do they work!?? (revised)
September 10, 2014
**Note1: For those who don't like to read long article, you can skip the first several paragraphs. Scroll down a bit, and jump to the text below the line. I clearly mark it for you.
**Note2: However, the first several paragraphs do introduce you to a bit of new knowledge as well. If you have time, read them all.
**Note3: I want to let you know that though I did some research before I wrote, my explanation is purely based on my thinking and the knowledge I have so far. So do not use this as a reference, unless it really convinces you that this article makes a lot of sense. ------------------------------------------------------------------------------------------------------------------------
I have been thinking of trying to post something new and refreshing to give a bit of breadth to the blog... and voila, there you have it. Today, I was doing some reading, and I came across the terms: "level of resistance" and "level of support" used in trading stock and forex. I do not know if these 2 terms are broadly used in any other types of trading like trading securities in general. That does not matter anyway.
Just a bit of additional info before we start. What are securities? By definition, securities are divided into debt securities and equities. Trading debt securities is none other than trading debt. An example of a debt security would be Bonds, like government and corporate bonds. In contrast, equities represent ownership of assets. Example? Stock, and that is what I am going to talk about today.
Our discussion will be related to stock market, but I am not trying to teach you about how to trade or how to make millions of dollars. If you read this article hoping to make some bucks, then the exit is right there.
I mean, come on, I, myself, have not even bought or sold any stock once in my life. How can I provide you with the million-dollar tips? Plus, I am a risk-averse person, probably because I have no money, which make any financial loss a huge deal for me. However, I have a decreasing absolute risk aversion trait. What does that mean? That means as I am getting richer, I will become less risk averse, and thus, the amount of wealth I am willing to expose to risk will increase. When that time comes, hopefully, sooner rather than later, I will give it a shot.
Neither am I going to explain you about stock, about stuff like long/short position... okay, may be a bit about the long/short jargon. Nothing much, really. Long means buy. Short means sell. Think of it this way; you have a line of cookies, and when it is getting shorter, then means you have sold some cookies to someone else. By the same token, when it gets longer, that means you have bought some cookies to include in your collection, the long line of cookies in your kitchen. Simple, but not 100% correct. There are more to long/short stock. They are not simply buy and sell, but buy and sell are close enough for the purpose of this article. For more information (if you are curious), please google them.
As you can see, I am not here to teach you Finance 101. I am here to talk about how the level of resistance and level of support are what they are, and why they have been used widely despite the lack of explanation. The thing is I have been going around trying to find a good explanation of why and how those two work, but sadly, I could not find any good sources on the web that provide a clear rationale of what is going on behind the scene (maybe, you can. Give it a try!). I can just imagine the frustration of students trying to digest this knowledge while having little idea of how it works and why it is there.
So, I am going to explain them by myself, using economics or just common sense. There is no secret to it. Things are the way they are because of a reason or two.
Enough chitchatting, let's get into business.
---------------------------------------------------------------------------------------------------------------------- **The real stuff begins here:
Before we begin, I want to introduce three important elements I am using today to make some sense of the stock shenanigans. (Note: There is not point in using the word "shenanigans" here. It is not even relevant. However, I just think it sounds cool and what to put it somewhere in the text. Try to understand it from the context only, not the exact meaning. lol)
You need to understand three explanatory elements and the definition of the two terms (support and resistance) before we can unravel the mystery.
First, knowledge of common. What is it? Knowledge of common is common knowledge. I just think it is cooler to use "of". Basically, it is the knowledge shared by either most or all people.
Second, rational expectation. Rational expectation is pretty much what rational people expect to happen as a result of their actions or some uncontrollable exogenous force or shock. Mostly, people use the knowledge they have gained from the various sources such as personal experience, media, books, grapevine and so forth; they then combine the knowledge of the past with the available information of the present to arrive at a final product, the conclusion in the form of expectation, a rational one. Can you see the connection between the first and second elements yet? Get it? People use knowledge to form a rational expectation!
Third, self-fulfilling prophecy. Just a heads up, in case the third element makes you think there is something spiritual about this article, the answer is No. No, There is nothing here for you if you want a fortune-telling. Anyway, self-fulling prophecy is basically a prediction that becomes true because people simply believe the prediction and act accordingly anticipating what foretold to be realized in the future. There are instances in which no matter how ridiculous or baseless the prophecy may sound to the logical thinkers, it can become true with enough people believing in it. That just means being logical is to take this fact into account when engaging in thought. So, can you see how the first, the second, and the third elements are connected yet? People believe in the prophecy (in the form of knowledge), act it out with rational expectation, and the prophecy is actualized!
knowledge of common, rational expectation, and self-fulling prophecy. We will use these three to explain level of resistance and level of support. However, to explain how and why they happen, I need to first clearly define the two financial terminologies.
The picture above will act as an illustration to aid your learning of the concept. They might look simple, but their inherent complexity is undeniable, even to the experienced traders. Let's not make life any harder that it is. There are simple definitions too.
Just like the picture shows, the level of support is a line, a price level, which stock price seems to have difficulty falling below. You will see that the price was pushed down several times, but it could not go lower than the level of support.
On the contrary, level of resistance is the price line, the price ceiling that stock price cannot seem to break through. As you can see in the picture, the price, most of the time, could not increase any further once it reaches the red line, and the fluctuation, most of the time, is within the band of the support line and the resistance line.
This concept is most useful in short-term trading. Why is that? Because short-term trading is influenced more by the profit-seeking behavior of individual traders who do short-term speculation based on their instinct or belief of when and at what point to buy and to sell. Unlike long-term trend, short-term trend is unlikely to be affected by real variables like exogenous (or external) economic shock, new innovation, new products or services, government policies, or any changes in the actual operation of a firm or the whole industry or the business environment. It is based mostly on the animal spirit of the people. That is, by my own definition, what short-term trading is, and this is when level of support and level of resistance work best.
So what does this tell you? It tells you that there are a lot of psychological factors coming into play here, and what I am doing now is using behavioral economics to explain why resistance and support lines exist. (Behavioral economics can be simply regarded as a branch of economics that studies human behaviour and how that influences their individual economic decision and the collective economy)
First of all, we have to understand that short-term traders are always interested in understanding the tools, the concepts to give them the edge in trading. Once level of support and level of resistance have been introduced, once the terms have been coined, people become curious and they study and study to absorb this new knowledge. Sooner or later, the concept becomes a common knowledge for the mass. This particular topic will be everywhere in school, in finance class, and people become more and more acquainted with it, more convinced that support and resistance lines actually work. Once enough people, whether or not they understand the underlying reasons, believe in support and resistance lines, this new knowledge will then become the knowledge of common.
This is when rational expectation comes into play. As you may have guessed, traders are rational people. Well, most profit-seeking individuals are rational. They make rational decision to arrive at a logical conclusion based on what they know, on the information they possess to speculate the future. You will see what I mean by "rational expectation". Keep reading.
Based on the past low stock price and its persistence to fall below that low mark, people start to draw a line and they call it support line. So when a large number of people expect that price will not fall below support line, they will want to buy stock at this point hoping to gain from the imminent increase in price. Voila, now everyone buys stock based on the expectation they form rationally. What does economics tell you? Buy = Demand. People demand more stock at the point of support line, and consequently, the price rises! This pattern repeats itself again and again a few times or many times, leading to what we call "the level of support". In the end, price really does not fall below the support line because people keep buying more stocks pushing the price up as it nearly reaches the support line.
This is what I mean by self-fulling prophecy. Enough people believe that price will not fall below the limit that they draw, they act it out as any rational being would, and due to this reason, price does not fall below the level of support. This further reassures people that level of support does work! So they continue to repeat and the result repeats itself as well.
Same goes for the line of resistance. Same process; knowledge of common and rational expectation lead to self-fulfilling prophecy. Enough people believe that price will not go beyond the resistance line. They start selling when price comes close to the line to gain the maximum profit because they know that price will soon fall. Again, what does economics tell you? Sell = Supply. As people sell their stock, the company's stocks pile up due to sudden increase in supply, and price simply falls as a result.
In the long run, however, stock price will follow the changes in the real-world variables. For instance, just like when Apple announces its new products, and its shareholders start to buy more stock due to their strong faith in the company believing its new products will bring Apple much more success as a company, and thus, a greater return for its shareholders. That is why we see either upward trend or downward trend of a company's stocks. This is one way to break through the support or resistance line.
And that's a wrap. I hope you enjoy reading and ingesting new knowledge just like how I enjoy writing this article. It is just refreshing being able to write something new once in a while.