Support Levels – A Myth That Won’t Die
Let’s first look at support levels. Support levels are a cornerstone of technical analysis and are commonly used by retail traders. They can be related to previous market lows or highs or drawn from unicorn/fairy trend lines. Some technical analysts even have other mystical, subjective ways to find support levels.
But here’s the problem, the method for finding support levels is essentially the same as for finding resistance levels. This brings in a key flaw in technical analysis, namely they use the same methods to analyse rising and falling markets. (Further examples include double tops and double bottoms, head and shoulders tops and bottoms).
Rising equities trade differently to falling equities
But do markets trade in the same way when they are rising and falling? Is the psychology the same just in reverse?
To some extent it depends on the market. In FX markets for example, there tends to be no long bias and lots of risk hedging, corporates etc. So at any point in time any particular free (i.e. not pegged) cross rate is unlikely to have an extremely high percentage of traders positioned one way. Falling Euro$ doesn’t necessarily mean that most traders are losing; many might be short.
But for equities the situation is different.
The vast majority of equity traders only trade from the long side; over 95%. So we know that when shares fall, most traders are losing money and when they rise, most are making profit.
This undoubtably means that the psychology and ultimately, trading style of equity investors will be different when equities fall compared to when they rise.
But technical analysis and their support and resistance levels assume an identical process just in reverse.
Falling markets can move faster and harder
When stocks are falling very sharply, this difference is even more dramatic. This is why volatility tends to increase substantially when stocks fall sharply, while it might fall when stocks rally. Anyone who studies volatility or the VIX Index will understand this relationship.
So most practitioners know that falling equities exhibit different characteristics to rising equities. yet technical analysts use the same analysis techniques for both.
No support in a falling market
Which brings in an old market makers term;
“There is no support in a falling (equity) market”
When stocks are falling sharply, market makers would love to find idiots traders who are trying to identify support levels. These ‘levels’ don’t exist.
Steeply falling equities are usually being hurt by some macro news or data event and will only turn around once the situation changes (Fed comes to the rescue etc). They don’t bounce off of support levels. (Of course, after the fact, my technical friends then refer to these lows as support levels.)
Selling Puts
Selling equity put options is also heavily promoted to retail traders and is in fact also used by some fund managers (there are sell programs for this strategy).
The theory is this:
- Stock GAZ is trading at $10.
- You like stock GAZ and would like to buy it at $9.50.
- So you sell $9.50 puts.
- If stock GAZ rises, you keep the premium.
- If GAZ falls to $9.50 you will be assigned and buy the stock there, but you wanted to buy it there anyway. Plus your purchase price is really less than $9.50 because of the premium you received for the option.
It’s a win-win right?
Wrong
In theory it sounds like a win-win but as Yogi Berra said “In theory there is no difference between theory and practice, but in practice there is”.
It’s easy to say, “I would like to buy GAZ at $9.50” when it is trading at $10.
But what if it fell there right now? Would you still want it?
Chances are there was some negative news that has caused the stock to fall so sharply and there will likely be more downside to come. With the latest information, you might not want to own the stock.
Again, your decision making would be different if the stock falls quickly and/or there is any new information (context). (Eliminating context is a key flaw in technical analysis in general)
Same Flaw
The flaw that support levels and selling puts have embedded in them is that they assume that investors are as just as happy to buy stocks lower, even if the fall is fast and large.
They assume the same type of rational analysis when investors are losing money as when they are profitable,
They assume that falling equity markets are the same as rising ones from a psychology perspective.
Further they also ignore the possibility of forced sales due to margin calls which are common during big market falls. Whereas, forced buying by shorts during rallies is less of an issue because short traders are usually a tiny percentage of the market.
This is not a small flaw. It dramatically changes the expected risk and reward of the trade and can severely hurt your account.
Summary
Support levels and selling equity puts have the same flaw embedded in them; a flaw which can significantly hurt you.
Note that FX markets have a different personality and so this topic relates differently in that environment. This goes to one of my (many) criticism of technical analysis in Technical Analysis Exposed – Why Most Technical Analysis Trader Fail (available here) namely that practitioners use the same methods across all markets even though those markets are clearly different.
Interestingly, as I show in the book, studies prove that technical analysis methods, while overall offering no value, do perform better in FX than equity markets and also perform worse in falling equity markets compared to rising ones. All of these findings support my analysis in this post.
Strategies based on flawed assumptions are unlikely to deliver long term profitability; in fact they are likely to blow up your account.
So do yourself a favour and avoid using support levels and stop routinely selling puts.
Keep Grinding
Gary
