I received a good question from Gareth this morning: “Your book is one of my top sources in trading literature, though there are some ideas that I find it difficult to agree. Specifically, I’ve found your idea of many support/resistance levels being created randomly hard to understand, since movement in every tick is the result of large institutional trading. Is there anything that I’m missing with this concept?”
This is a good question, and there are at least two good points to consider.
First, is that even deliberate action can result in random motion. For instance, think of throwing a piece of fish food into a tank full of small fish. Though I’ve never analyzed this scenario (and I’ll wait for someone to email me and tell me why I’m wrong), I’m betting that piece of food, if we were to run the experiment over and over, would move randomly on the surface of the water. However, each fish is not moving randomly! Each fish is trying to get a piece of food in its mouth, and it’s doing so with the deliberate eating strategies a fish has honed over eons of evolution and selection. Fish are good at eating, and this is what each fish is trying to do.
But, their actions together are a mess. Sometimes two fish hit the food from opposite sides and cancel out. Sometimes more hit one side than another. Sometimes one comes from far away, so he’s moving very fast and imparts a lot of energy to the food. You get the idea: no individual fish is acting randomly, but their actions as a whole could be very random.
It’s the same in the market. People buy and sell for many different reasons. Even if you think a stock is a screaming buy, there are a lot of people selling too. In some cases they are selling to establish shorts. In others, to take profits on longs. (Maybe they knew it was a screaming buy months before you figured it out!) In other cases, they may buy and sell for unrelated reasons: I could very well establish a bullish options position that might involve selling the stock. The list goes on.
The second reason is that I think one of the worst offenses in the “educational” literature is the idea that each and every tick has significance. I believe quite the opposite is true, particularly when analyzing intraday bars. Most of what we see is random. The idea that someone has to take the other side of your trade is silliness–no one who has any idea how markets work could actually believe this. (See previous paragraph again.) The big picture structure is important, and some elements are important, but much of what we see is probably just patterns that pop out of a soup of randomness and touch some of our cognitive biases–in other words, they aren’t real.
Is support and resistance random? I don’t know… there’s no reliable way to answer that. I can show you that there is unusual activity around certain kinds of levels, which strongly suggests those levels might not be random. I can also show you that any line drawn on a chart will appear to be meaningful and non-random to a trader; you cannot trust your sense and perception about this. So I do think that a lot of what passes for technical analysis, being driven by observation and untempered by actual analysis, is simply people finding patterns that appear meaningful, but actually are not. Sadly, books and entire disciplines have been anchored on these concepts, and much of modern TA is less than useless because of this.
So, yes, I’d say what you’re missing is a full understanding of the potential for action in the aggregate to be random, even if the actions of the individual actors have clear intent. The markets may be much more random than we’d like to believe… at least consider that possibility.