In our quest to understand trading options for income, we often rely on indicators or studies to determine direction and entry/exit points. This falls into the category of technical analysis, and Resistance and Support is a key technical indicator. In this article we will discuss the efficacy of Support and Resistance.
As advocates of the Probability Model, we believe in the underlying principal of the Black-Scholes option-pricing model that considers the action of the markets as essentially random. We have conducted our own research, which draws the same conclusion as dozens of white-paper research documents, which supports this principal. Therefore, any study or indicator that relies on prior information to form a prediction of future price action has a probability of 50 percent (at best) of being correct; it is essentially a coin toss.
Support and Resistance levels rely on prior price action, and therefore it has little predictive value. To understand why so many traders employ Support and Resistance levels for entry and exit signals, we need to understand its allure.
What is Support and Resistance levels? They are horizontal lines that generally connect two or more points on a price chart, or are Fibonacci levels (based on the high and low of a range of prior prices), or Pivot Points (calculated from a mathematical formula of the open, high, low, close of prior price action). When the price of an underlying reaches a Support or Resistance level, it is expected to reverse direction.
If Support and Resistance has no predictive value, then why do so many traders rely on it? First, it has been around for so long, it is hard to resist. There is far more information about Support and Resistance (it has been in use long before computers made other technical indicators possible) that it is always considered by traders before placing trades. As such, many directional trading strategies employ Support and Resistance levels, especially for day trading.
Second, it has visual appeal. When viewing a chart, it is easy to see areas of price action where there are reversals; we cannot easily see where it did not reverse. Therefore, easily identified price reversals tend to support our belief that the price has reversed because it is a key price level, when it is actually random price action.
Third, most traders look at Support and Resistance levels as areas; not a specific price. This will increase the odds to slightly higher than 50 percent because an area of Support and Resistance encompasses more prices than simply specific price levels. For example, a Resistance level may be identified at $123; the probability of reversal at $123 is 50 percent (it is random). However, if we consider the Resistance level to be in a range from $121 to $125, we have included a broader range of prices, which will improve the odds (consider broadening the range from $110 to $135 and you begin to understand that the probability of a reversal increases). Of course, the broader the range, the more difficult it is to determine where the reversal should occur.
Fourth, at round price levels (i.e., 1800, 1825, 1850, 1875) is where a majority of Stop orders are placed. When these levels are reached, a large number of reversing orders are initiated resulting in price reversal. On the chart, this gives the impression of Support or Resistance; but once the orders have been filled, that level may no longer be significant.
And fifth, random price action can have a string of runs. For example, in a coin toss, it is possible to see heads appear 3 or 4 times in a row, reverse, then offer another string of heads. This is the nature of randomness. Of course, on a chart a string of runs will look significant when it actually is not.
In conclusion, Support and Resistant levels are reference points or guidelines for where there is a possibility of price reversal; especially at round price levels. However, these levels do not provide any predictive value. A good discussion on this topic can be found on the Tasty Trade video.
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.