Friend or Foe? Horizontal Lines in Trading Charts
What is a horizontal line? It is a line which runs from left to right in a chart. Maybe that was too obvious. OK let’s think about a chart.
All trading charts are 2 dimensional. In a 2d chart, there are two axes. Horizontal axis we call x-axis, vertical axis we call y-axis. In the above chart, the x-axis represents time while the y-axis represents price. Horizontal lines we draw on a chart is parallel to the x-axis which means it will cover a length of time but the point in y-axis will be all the same.
Why am I talking about this middle school math? Because the definition of a horizontal line we learned at middle school can help us understand what horizontal lines are for in forex trading. Combining the two characteristics of the horizontal line, in forex trading, this line means a price important enough to cover a length of time. For us traders, important prices are where the price stops or stops and reverses either short-term or long-term.
Resistance and Support
Resistance is a price level where uptrend tends to pause and in a chart, it looks like it’s working as some kind of invisible ceiling.
In the above chart, I put three resistance lines starting from R1 on the top to R3. Let’s look at R1. R1 has first worked as resistance at the point R1-A and when the price came near R1 it again worked as resistance at the point R1-B. There is one important thing we need to remember and keep reminding ourselves when trading. In market movement, nothing is 100%. Nobody can predict market 100% correct, no chart pattern will work 100% of the time, no strategy will win 100% of the time. If anyone claims 100%, that’s a clear sign that it is not legit. Everything we see, hear, think should always be based on the concept of probability.
Horizontal lines are no exception. A resistance line which worked multiple times in the recent past has a high chance of working as a resistance in the near future. But it may not. The price may pass through resistance and continue to go up.
How resistance lines work and why do they work as they do? Because it’s human who makes the market move by buying and selling. Let’s say you put a buy order just before the point R1-A. It looks like it is in an uptrend (the low of the wave has been updated to a new higher low, and it went up beyond the recent high), so you entered as a long position. But sadly the market didn’t go as you expected and changed its direction to a downtrend. You waited but ended up exiting with a loss. The second time you entered with a long position a bit below the last price level you entered. After some battles between buy and sell in the market, it finally turned to your direction and went up to a level where it changed direction last time. What would you do? Would you wait in the hope of the price going up even further? There’s an old saying that explains well how human behaves in this kind of situation. Once bitten, twice shy. Yes, many people will think here, “Hmm it didn’t go higher than this last time. I might as well just take profit here and see how the market goes”. A long position’s profit is realised by selling the position, and what happens when there is a concentration of sell orders? The price goes down.
In another scenario, let’s say you expected the market to go down where it reached R1-A and entered with a short position. Luckily, your prediction was correct and you closed the position with a huge profit. After a while, the market climbed back up to a level where you entered the short position last time. What would you do? Considering that it gave you a huge profit last time, you might as well do the same this time.
This is closely related to what they call “operant conditioning” in psychology. When our actions are rewarded we likely to repeat the action, while on the other hand when actions are punished we likely to stop the behaviour.
The same principle applies to support lines. It is where new buy orders likely to concentrate and old sell orders likely to take profit because of the same reason. Because the price bounced and went up around that price before. We tend to think what happened once can happen twice.
What’s interesting here is some of the support lines in the above chart are actually the resistance lines we saw earlier. There seems to be an interesting relationship between support lines and resistance lines.
Role Reversal
A line that we trusted as a support or resistance becomes the opposite (support -> resistance, resistance -> support) when it is violated. It’s like Harvey Dent who used to be the strongest ally of Batman became a villain Two-Face after he got the scar on his face. What makes it change? Who is throwing acid on our lines?
The answer is us, traders. Remember? Every movement in the market is decided by humans buying and selling. Let’s look at the line “S4 / R2” in the above chart. It worked once as a support line, so when it came near to that level, you opened a long position. But uh-oh, the price didn’t even stop there and went further down. Now your open position is with an unrealised loss. Then thank god, the price came back to the level of your long position. What would you do? Considering that it already violated the support level you trusted, it wouldn’t be a smart choice to hold on to that position in the hope of the price going even higher. This is your chance to at least break-even. Would you not take that chance?
The reason why this support line became resistance line is because the concentrated buy positions around that level will be closed by selling when the price reaches back to that once support level. Again the same principle applies to the case of resistance becomes support after it’s been violated.
Through this post, we have looked at the meaning of horizontal lines in trading charts. Their roles as support and resistance, and also their two-faced nature. I haven’t decided what I should write about in my next post, but at the moment I’m tempted to write about the double top, double bottom chart patterns. Thank you for reading.
Originally published at waxmurderer.com on February 24, 2019.
