There is not much doubt that when using technical analysis that support and resistance are key concepts. As a matter of fact, ‘support and resistance’ are interchangeable with ‘supply and demand’, and the concept of supply and demand is precisely what makes the market move. When there is a certain price point which brings out enough buyers to outnumber the potential sellers, we say there is ‘demand in that area, and the resulting ‘wall’ that shows up on a price chart becomes a ‘support’ area to the technician.

This ‘support’ area forms because of the belief that there was strong buying there at one point in time, so there will always be strong buying there in the future. Obviously this is not always true. This is what frustrates traders sometimes. In reality, there are three ‘types’ of support. There is a ‘memory affect’, which states that there were a lot of buyers here before, so there will be again. If this happens on a regular basis, many traders refer to this as ‘major support’. Next, there is minor support, which we are going to talk about in this article. Despite its name, minor support usually offers the strongest form of support. Then there is ‘self-fulfilling prophecy’ support. This is simply the belief that everyone has that something will happen, so it does.

Self-fulfilling prophecy actually can overlap other support concepts making them more effective, but it can also be a totally unique support concept. Some moving averages are a good example of this type of support. While there is some mathematical significance to moving averages, when a stock falls seven dollars to the 200 period moving average on the daily chart and stops dead, it is often doing so just because that is what everyone expects. Do not think that this necessarily makes it less effective; the effectiveness can only be judged by what kind of buying or selling actually takes place. Naturally, like all trading concepts, if more than one type or support or resistance is happening in one area, it can only be better.

We are going to take a look at minor support in this article because it is perhaps the strongest of all. The reason is because it is the only support where we have traders that ‘have to’ buy or sell in an area. All other supports happen only because traders may ‘want’ to buy in an area. Why would a trader ever ‘have to’ buy or sell? Take a look at the two minute chart below of URBN:

There is a base that occurred the prior day, under the red lines, that set up a resistance area. Traders may have been shorting this area, and/or traders the next day may have used that base to decide to short the opening 10 minutes the next day at ‘1’. Either way, whether you love this play or not, it is a reasonable shorting idea that will have short players involved. The break out above this area was somewhat of a ‘surprise’ shocking move. We know this has the affect of ‘trapping’ a lot of traders. The truth is, we know the most traders do not take their stops. Most traders lose, and the market is filled with newbies every day. For all these people, the rally coming becomes very painful. With every penny up, they are losing more and more money. At ‘2’ they are yelling and reminding themselves they need to follow stops. At ‘3’ they have their head on the desk and are writing post-it notes to follow stops. At ‘4’ they have walked away or are praying to a higher being for help.

Now, here is what is key. What is everyone’s only goal when they get in this much pain? It is to breakeven. Not a reduced loss, not a small loss, but to be slightly green or break even. Why? Because then, and only then, they are not a loser. The biggest psychological demon that everyone battles is the FEAR of being a loser. So if the goal is to breakeven, when does that happen? Only when we get back to ‘5’ which was the original shorting area. This is why minor support works. There is the memory affect of the last rally, the self-fulfilling prophecy of the base, and the prior losers who are now adding fuel to the fire by buying to cover their shorts. If you think with this philosophy on all areas of a chart, many concepts become much clearer to you.

In summary: Minor Support is created when resistance is converted to support as a result of a break-out and re-test of that level; and Minor Resistance is created when support is converted to resistance as a result of a break-down and re-test of that level. In an up trend, Minor Support is revisiting a prior high (resistance) after that level has been breached; and in a down trend, Minor Resistance is revisiting a prior low (support) after that level has been breached.

Support and Resistance, Part 2 of 2