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Dispelling Myths and Defining Terms
The late 1970s and early 1980s marked a strong uptrend in energy prices. During the summer of 1979, heating oil futures tested the $1.05 per gallon region and then quickly returned to around $0.72/gallon. This failure to rise above $1.05/gallon defined that area as resistance, or the level at which the upward price momentum was thwarted.
Over the next few years, the market would again test the $1.05/gallon resistance level and again that price level would act as a ceiling, preventing penetration to higher price levels. In fact, the $1.05 level would be retested in 1981, 1982, and 1984 without being breached (see Figure 1.2).
In terms of market psychology, the $1.05/gallon level emerged as an important resistance mark and price trigger. Consider the significance of the $1.05 price level to various market participants. First we examine traders who bought $1.05 in anticipation of trend continuation. Instead of accepting a small loss as the rally gave way to retracement, some of these buyers actually suffered through the gut-wrenching despair of watching prices fall to $0.72/gallon. As the market again approached $1.05 their despair gave way to redemption, and they seized the chance to exit without a loss by offsetting their prior purchases with a break-even sale (see Chapter 3, Cutting the Tails of Our System’s Distribution).
FIGURE 1.2 Rolling front-month Nymex heating oil futures showing $1.05/gal horizontal resistance.
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MECHANICAL TRADING SYSTEMS
Those who sold the $1.05 area obviously enjoyed superior market knowledge, and it is logical to assume that the majority of them realized a considerable profit by covering their short sale at lower levels for a profit. As the market again approached $1.05, they are even more aggressive in repeating what had proved a successful trade in the past since the market has now defined the $1.05 region as a low risk/high reward trading opportunity. (These traders can initiate short positions at $1.05; place a stop loss order at $1.06 and a limit order to close out the position with a profit just above $0.72.)
Consider those with sideline regret/remorse (see Chapter 3, Cutting the Tails of Our System’s Distributing). These are players who anticipated the end of the bullish trend but failed to capitalize by selling at $1.05. As the market came off from the $1.05 level, they watched from the sidelines in anguish, fearing that selling after the market retreated from these levels represented too much risk and not enough reward. The resurgence to $1.05 signifies their redemption as well since they can now “sell the top” as they had originally hoped. There is a much greater likelihood of them executing sell orders this second time around, since the top is now a clearly defined price level as opposed to an amorphous sense of the market being “overvalued.” (Note: All of these same psychological factors—break-even syndrome, sideline regret/remorse—apply to support levels in downtrends.)
Finally, what happens if the buying pressure becomes strong enough to satiate the selling represented by all of these trader types? In that case, the market psychology associated with the $1.05 trigger level is reversed as shorts with unrealized losses seek to exit positions at breakeven. Consequently when the market moves above the old resistance level at $1.05, then retests that price level, former sellers buy back short positions, thereby supporting the market against lower prices. This is why old resistance, once broken, becomes new support and old support becomes new resistance.
Psychological Significance of Price Triggers: Horizontal Support and Resistance Levels: Corrections
Another example of market psychology in relation to price triggers is the tendency of trends to experience temporary, countertrend reversals within the context of the larger dominant market trend.
Such minor countertrend reversals are called corrections, retracements, or pullbacks and typically are measured from the lowest low of the prior trend to the most recent highest high in bull market trends, or from the highest high of the prior trend to the most recent lowest low in bear market
Dispelling Myths and Defining Terms
trends. The strength or weakness of the dominant market trend can be determined by the severity or mildness of these corrections.
The psychology behind market corrections is as follows. Hedgers and short-term countertrend traders establish countertrend positions into logical price target areas that are often long-term support or resistance levels, as discussed above. (Trend-following traders also may exit with profits at these logical price trigger levels.) As the market returns from its highs or lows, intermediate and short-term trend-followers take profits, accelerating the correction. Adding fuel to the corrective fire, the retreat from recent highs or lows is accompanied by a “shaking out” of weak or recent longs or shorts—those that are undercapitalized or have little tolerance for drawdowns in equity.