This is a followup to the series of posts I already did on randomness in markets. I have received quite a few questions, both from blog readers and from traders I mentor, about specific kinds of levels. I have been trading a long time and have seen so many different ways of calculating support and resistance. I have studied a lot of these things in some depth… everything from the standard Gann stuff to “floor trader” pivots, to Drummond geometry trendlines, to Fibonacci levels, Hurst cycles, and then you have the “mathemagical secrets” like the Camarilla Equation (Google it if you’re curious, but don’t waste more than 2 minutes thinking about it.) I have also run into many traders who are passionate about the merits of one method or another, and their justification is always (pay attention here… this is important) that “of course these are good levels. look at price action around the level. look at this example. look at this one…”
I was one of those traders until one of my mentors dropped a real bomb on me. (He was a former floor trader in the grains with a strong mathematical background.) He gave me a series of levels and asked me to take a look at them and let him know what I thought. Assuming these were some kind of ratio/cycle method I spent a day digging into them and came back with multiple examples of how amazing the levels were. Turns out… you probably already guessed the punchline… they were completely randomly generated. I was in complete disbelief until he invited me to draw some random lines on charts and repeat the analysis… then I was shocked and disillusioned as I saw these random levels looked just as good as my prized pivot levels I had generated. Everything we think we see in our “real” levels we also find in random levels: perfect tests to the tick, multiple tests, support failing and becoming resistance, gaps through the level that hold on a retest… the list goes on and on. What is happening here is that price action is random enough that any defined level will set some expectations for the trader, and then our highly evolved pattern recognition abilities kick in… and, in the absence of real patterns, the brain is happy to create patterns for itself…. and so we find ourselves back at one of the fundamental issues in trading–the difficulty in distinguishing between actual pattern and random data.
Now, please be clear what I’m saying. I absolutely am not saying that support and resistance are useless or that they are not a real concept. They are and they are. ( I do use support and resistance in my trading, but they are usually pretty far down my checklist of what I consider to be important.) What I am saying is that most of the levels you are using may not be as valuable as you think they are… even if they “look good” to you on charts, I would encourage you to honestly ask yourself if they are better than random levels… and you have no way to answer that question if you don’t have some experience looking at random levels as if they are real.
Please take a look at the short video below that I recorded. It is not particularly well done or well planned, and I apologize for that, but I wanted to give you the first shot I did at recording this. Otherwise, I could have recorded it 20 times and picked the one that looked the best! I think the method I use to generate random levels is kind of interesting: I basically hid the price bars on a daily chart, drew horizontal lines, and then looked at where those lines would have hit a 5 minute chart intraday. (As you repeat this exercise, consider other ways to generate random levels on charts.) As we go through the 5 minute chart, pause the video and look at how the day’s price action interacted with these “levels”… assume that you believed each of these red lines represented an extremely significant price level before the market got there. In how many cases would the price action have supported that assumption? Once you have watched this video and thought about it, I would invite you to repeat the exercise yourself. Please don’t take anything I tell you at face value, but use it as a departure point for your own learning and analysis. Draw random levels on charts and check out price action around them… then look at price action around the levels you are using (especially if you think you have great levels)… and then honestly ask yourself how much better your levels are than these random lines on charts.
Probably not one in a thousand traders is aware of issues like this. If you know that you can draw any line on a chart and find it working as support and resistance, how would that change your approach to the markets? How will it change how you use support and resistance? How does it change how you evaluate your trading results around these levels? I think these are profoundly important questions, and it’s worth some time to carefully consider the answers here at the end of another year.