Reader Andre asks two questions in response to my post on the failure test trade:
It seems that you do not take in consideration any kind of volume information when analyzing the price behaviour around the support/resistance level, is that correct? (like for example the volume on the second level test)
Correct. I know that many authors and gurus talk reverently about volume, but I have been unable to verify its importance. Now, understand carefully what I’m saying—I’m not saying that volume has no importance. I am saying that, through many years and many, many quantitative tests, I have yet to see a single shred of evidence that supports the importance of volume. I know that this is one of the sacred cows of traditional technical analysis, and I know there are many logical reasons why volume should be important. All I can tell you is that I haven’t been able to prove that. (Perhaps my tests are flawed, or there could be many other explanations.) Furthermore, I know other people have had similar results when they try to verify the importance of volume. Thomas Bulkowski (see Encyclopedia of Chart Patterns) was surprised to find that, when he separated chart patterns into those with and without the “correct” volume cues, there was no difference in the quality of the pattern.
You can and should verify this yourself. Here’s an idea:
- Find many (more than 200) examples of a particular pattern on the timeframe you use, without paying attention to volume.
- Go through the patterns a second time, separating them into two groups: those with good volume patterns supporting the chart patterns, and those without.
- Now, go through each of the groups, and somehow score the patterns. From a quantitative perspective, we would look at returns following the pattern (for instance, mean return and standard deviation of those means), but you might just score them 1-5, ranging from 1= great winner to 5=big loser.
- Compare the outcomes from the two groups with and without volume support.
The answers to all your market questions are right there in front of you. Don’t accept anything because a book or a guru tells you—verify it yourself. As one of my mentors used to say time and time again, “let’s ask the data.” Go to the market and see what it has to say.
Should we consider support/resistance as a fixed price or more like a region? Sometimes it is not clear for me where a specific good support/resistance price is.
In almost all cases, support and resistance areas should be thought of as broad “zones” or regions rather than precise price levels. If you’re drawing in a chart, a crayon or one of those jumbo pencils children use might be the right tool, rather than an architect’s pen and straightedge. I spend a lot of time in the book talking about support and resistance levels, and practical issues in identifying and using them. You’re correct—this is not as easy as it seems.
Thanks for the great questions. As always, please feel free to drop me an email firstname.lastname@example.org with any further questions and I’ll see if I can use them in a future post.