Last updated on May 31st, 2016
We have all heard of the old adage….”sell at resistance and buy at support” which is another way of saying to trade market structure.
Obviously it is contextual because if price is charging towards a resistance level are you really going to just going to market short?
Of course not and to just trade these levels blindly will not result in positive results overall especially if you also ignore your risk parameters.
That is the problem with these types of “rules”.
They ignore the fact that markets don’t move according to popular statements.
Patterns Are Market Structure
What about chart patterns which are another form of market structure.
They all come with their own names such as wedges and triangles, their own rules and “meanings” but at the end of the day, it is a theory that they will simply respond to the textbook definition.
Why is this a big deal?
It is a big deal because if you just trade according to the definitions you are leaving out, again, that markets don’t always respond to the common methods of trading.
If you also understand what is going on at these levels, do you think you will have a higher probability of success?
Because you will know what the follow through action should look like.
Let me explain……..
Support And Resistance Structures
What happens at a resistance level? Actually, a better question is what could happen to price when it reaches these levels?
Once you ask yourself what could happen, you open yourself up to more possibilities, are accepting that textbook plays may not always work and that these zones are really “potential” areas of support and resistance.
Understanding that they may not act according to your expectation hammers home that these levels, regardless of how many times price was rejected, are only potentially support and resistance zones and will only be confirmed if price rejects once again.
First thing though, you will first want to determine what constitutes a resistance level. Some traders will use previous swings while others will want to see a zone where price has moved away from more than once.
Going further, some people will use channels or even Fibonacci levels but these are not truly “structures” in the market.
If we look at the structure behind a resistance level what do you notice? Well, you can’t really “see” what is behind the structure however unlike theory, this is how the market works.
In this graphic, we see price moving solidly towards a resistance level.
At these levels, there are different orders in play.
The first line (white line) represents traders looking to short at this level. These traders are most likely looking to trade in the direction of the overall trend and if shorting a resistance zone, the overall trend will be down.
On the flip side, the overall trend could be up and traders are looking to “catch the top” and short at this level for a counter trend play.
Violated Market Structure
If the short fails, as in price wants to continue higher, what comes next? Those short players need to exit their trade at the red line where they no doubt placed their protective stop order.
Textbook S/R trading, right? The “rules” say place your stop just on the other side of structure
Just above that at the blue line, we have breakout traders with buy stop orders waiting for the break. Textbook breakout trading, right?
Wait! The big players, the ones that move the market, love these areas.
Let’s say they want to fill a short order. If they just short anywhere on the chart, their sells will drive their prices down. Their fills, are not as good as they could be if they could sell at higher prices OR have their sells cause minor ripples instead of a big drop.
Where do they want to fill orders to benefit themselves?
At these “textbook” levels.
How great is it for them to push price into the level, trigger the sells but continue the run to trigger the stops? It is great for them as they get a better price on their sells. Even if their selling pushes price lower, they still will get an average price much better than just shorting at the level.
This example has basing before the resistance level in the form of a converging range. These often deliver strong continuation just as often as not which flies in the face of common trading wisdom.
Look what price actually does.
It breaks the range to the upside, triggers the short players, stops them out and then tumbles to the downside.
This is a common pattern with either support or resistance zones and it is called a failure test.
Understanding what can happen at this level, can you see how a failure test setup could help you avoid being too early in a move?
Right But Wrong Is Wrong
Traders looking to short were correct on direction and wrong on timing even though they followed conventional trading wisdom including where to place the stop.
We are going to keep moving forward on the chart as shown by this next graphic.
This shows another failure test but in fairness it is not as clean as the previous example and also appears from inside of a range.
It’s a good example however of the importance of proper risk protocols and taking your stops when appropriate.
Astute traders may have seen a lack of participation in the short as evident by the small candles after the test and actually booked a small profit on this trade.
We see price break resistance with momentum and then form a range on the topside of what was the zone of interest. This pattern given the context of what has occurred may signal to some traders that the bears are unable to regain the zone as you can see clearly the upper shadows shows short interest but the lows holding the topside of resistance.
Knowing this, could you figure out a way to dissect price movement around these levels and know with a high probability which way price is likely to break?
You sure could. You simply have to open your mind to this concept but always understand that price does not have to do what the textbooks say.
Importance Of Risk Protocols
Making a case for each of the examples above was a simple process aided by knowledge of what can occur at these levels even though we would have taken a small profit or a loss on one of them.
This hammers home the importance of understanding the concept of risk when it comes to trading. In this case we are just referring to the obvious risk of being stopped out as there are other forms of risk.
You will want to ensure that your stops are in places around market structure but outside the range of common plays like upthrust and springs (failure tests). There are ways to do this including volatility based stop placement using the ATR indicator.
Playing market structure as your main approach to the markets is extremely viable as long as you take into account what price can actually do in these zones.
Price action and forming structures around these zones can often point to the higher probability play and as the same with all other market approaches, be consistent.
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