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Do Support & Resistance Levels Work?

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Written By
Dan Buckley
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.
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Updated
Mar 2, 2024

Many traders rely on support and resistance levels to chart price movements and predict buy or sell signals.

However, the effectiveness of this technical analysis strategy is a subject of debate.

We’ll explore the broader question of whether support and resistance levels work.

 

Key Takeaways – Do Support & Resistance Levels Work?

  • Limitations of Support and Resistance
    • The effectiveness of trading strategies based on support and resistance levels is debated, given the sheer dimensionality of factors that influence prices and financial variables.
  • Psychological Barriers
    • Whole numbers act as psychological focal points for traders and are often influenced by option prices and hedging activities, which can lead to price clustering at these levels.
    • This can influence price movements.
  • Retail vs. Institutional Strategy Divergence
    • Institutional traders prioritize analytical approaches over technical indicators like support and resistance.
    • They focus on quantifiable data and models to guide trading decisions.
    • There’s generally a significant strategy divergence between retail and institutional traders.

 

Limitations

While support and resistance levels aren’t considered entirely meaningless, we’d caution against relying on them as primary trading signals. 

Here’s why:

Correlation, Not Causation

Successes attributed to support and resistance trading may be coincidental.

These levels don’t directly cause price changes; they reflect what’s happened in a backward-looking way after other more influential factors have played out.

Sustainability

Strategies built on support and resistance are likely to be unsustainable in the long run.

 

Whole Number Psychology

Round Numbers as Focal Points

Whole numbers (e.g., $10, $50, $100 for stocks/commodities, 1.1000 for currencies) act as psychological barriers or targets for traders.

Many traders/entities tend to place buy and sell orders at these round numbers because they’re easily identifiable and appear significant.

There’s also more likely to be trading activity at these levels and tighter bid-ask spreads, which can further incentivize placing orders at these levels.

Order Clustering

This concentration of orders at whole numbers creates areas where prices can potentially stall or reverse.

If there are many buy orders at $50, an approaching price might bounce off that level (support).

Conversely, many sell orders at $50 could halt an upward move (resistance).

 

Options Market Influence

Strike Price Concentrations

Options contracts often have strike prices clustered at whole numbers.

Options with high open interest (lots of contracts held) at a specific strike price can influence the underlying asset’s price.

Market Maker Hedging

Market makers, who provide liquidity in the options and securities markets, need to hedge their exposure when there’s a large amount of options activity at specific strike prices based on their specific criteria (e.g., delta and gamma hedging).

Their hedging buying or selling to offset risk can push the underlying asset’s price toward those option strike prices.

The Pinning Effect

This refers to the tendency of an asset’s price to gravitate toward a major options strike price close to expiration.

Market makers’ hedging activity gets more intense as expiration approaches.

This can potentially “pin” the asset price near the strike, and you tend to see this a lot in individual stocks with high options activity.

 

Considerations

Self-Fulfilling Prophecy

When many traders focus on the same support/resistance levels, their collective actions can reinforce these levels.

It becomes a self-fulfilling prophecy, as the expectation of a reversal at a certain price can lead to the trading decisions that create that reversal.

Beyond Whole Numbers

While whole numbers are important, support and resistance can exist at any price level.

Technical analysts use tools like moving averages and trendlines to identify other potential points of interest.

Not Infallible

Prices can break through these levels, so they should be used in conjunction with other forms of analysis and risk management techniques.

 

What Institutional Traders Focus On

Large hedge funds take a more analytical approach to trading, studying factors that they believe have a deterministic impact on prices.  

Their strategies center on, e.g.,:

  • Sophisticated metrics measuring investment risk, market correlation, and sensitivity to variables like interest rates.
  • Analyzing how interest rates and borrowing costs influence trading decisions.
  • Emphasis on quantifiable data and models that demonstrate reproducible profitability, which lower the reliance on intuition or technical indicators.

While individual traders might trade currencies with technical indicators and support/resistance levels, institutional traders tend to focus on a much wider variety of data and variables to determine how they make trading decisions.

For example:

 

A Word of Caution

Support and resistance levels can provide price points to monitor, but building your entire trading strategy around them can lead to disappointing results.  

Experienced traders, especially those managing large funds, focus on the broader set of underlying cause-effect mechanics that drive markets.