Monday, March 22, 2010

Support and Resistance, Predictable A Priori ?

As you know, I have always found support and resistance trading to be one of the most reliable and simple ways to achieve long term profitability in trading in general. It is not a secret that this tactic is used by some of the most successful traders out there, making profits in virtue of its evident simplicity and elegant way of portraying market behavior. Through most of my posts talking about support and resistance I have always talked about how we can tell future S&R levels based on what previous levels were in the past. However, a very interesting question arises when we look at some of the tactics used in trading. For example, Fibonacci lines attempt to predict the position of S&R levels within trend retracements without any knowledge of previous market behavior, assuming that the market tends to "magically" stop around these lines. The Murray math lines follow a similar premise. Is there any truth to these claims ? Is it true that we can in fact predict S&R levels based on these "magic lines ?

It is clear that S&R levels can be infered from the past by looking at previous price action. For example, if 1.5000 was an important support level in the past on the EUR/USD then this level is also bound to be important in the future. There is nothing mysterious about this assumption since price levels where price has stumbled in the past will be places where it will stumble in the future. This simply plays on the assumption that the levels were important for a reason and they will be important in the future again for similar reasons.

However, certain trading techniques attempt to predict the extent of market movements without any knowledge about the currency pair's trading past. For example, Fibonacci theory suggests that price is bound to retrace only up to meaningful Fibonacci levels (levels which comply with the golden ratio) which are 23.6%, 38.2%, 50%, etc. Is it true that price has a statistical tendency to retrace to these levels ? Moreover, does price have a tendency to retrace to ANY particular level in forex trading ?
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The most common scenario we find is that price does NOT have any statistical tendency to retrace to specific Fibonacci levels. In fact, price rarely reaches any of these levels to "the pip" and retraces. What often happens is what you see on the image above. Price reaches the Fibonacci levels and retraces either between them or around them but almost never exactly on them. The fact that people who use Fibonacci say that it works so well is simply because instruments have a tendency to avoid extreme retracements of +70% on trends and many S&R levels are bound to be found between a 0 and a 70% retracement. Indeed, if you draw a lot of lines on a chart, price is bound to retrace from some of them making you think that you have "nailed" some fundamental aspect of market behavior.

In reality, what happens is that technical tools like Fibonacci lines and Murray Math plot levels which are bound to coincide with historically predictable support and resistance levels, being very close to them (giving the appearance of significance). Therefore, there is almost no validity to using these techniques when using historically valid S&R levels proves to be a much more straightforward and reliable way to pinpoint support and resistance levels. Therefore, it is not true that Fibonacci techniques or Murray Math are able to accurately predict S&R levels a priori, they rarely predict them to the pip and often they simply match levels or are "close to levels" which are much better determined through an analysis of the past S&R values of the traded instrument.

If you would like to learn more about my automated trading systems and how you too can learn to design, program and use your own long term profitable trading systems please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

1 comment:

Tcxmon said...

Daniel-

I agree in that I don't find support and resistance information gives a tradable edge.

For example, with the recent high of EUR/USD at about 1.5150, trend followers are going to place their buy stops above that previous high so they are in on a breakout. That makes it more likely that those price levels will be acheived (once we get a lot closer) followed of course by a retracement back down.

So its almost like a contrary indicator where sometimes resistance holds, and other times it doesn't, and can't tell ahead if time which its going to be.

So i'm not sure if an EA can be mades out of S/R data. Interested to see what you come up with,

Chris

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