Let’s assume that a market starts to move higher from a support area where prices have been fluctuating for some time.
The longs (those who bought near the support area) are delighted, but regret not having bought more. If the market would dip back near that support area again, they could add to their long positions.
The shorts now realize (or strongly suspect) that they are on the wrong side of the market. (How far the market has moved away from that support area will greatly influence these decisions, but we’ll come back to that point a bit later.) The shorts are hoping (and praying) for a dip back to that area where they went short so they can get out of the market where they got in (their break even point).
Those sitting on the sidelines can be divided into two groups—those who never had a position and those who, for one reason or another, liquidated previously held long positions in the support area.
The latter group are, of course, mad at themselves for liquidating their longs prematurely and are hoping for another chance to reinstate those longs near where they sold them.
The final group, the undecided, now realize that prices are going higher and resolve to enter the market on the long side on the next good buying opportunity.
All four groups are resolved to “buy the next dip.” They all have a “vested interest” in that support area under the market.
Naturally, if prices do decline near that support, renewed buying by all four groups will materialize to push prices up.
Now let’s turn the tables and imagine that, instead of moving higher, prices move lower.
In the previous example, because prices advanced, the combined reaction of the market participants caused each downside reaction to be met with additional buying (thereby creating new support).
However, if prices start to drop and move below the previous support area, the reaction becomes just the opposite. All those who bought in the support area now realize that they made a mistake. For futures traders, their brokers are now calling frantically for more margin money.
Because of the highly leveraged nature of futures trading, traders cannot sit with losses very long. They must put up additional margin money or liquidate their losing positions.
What created the previous support in the first place was the predominance of buy orders under the market. Now, however, all of the previous buy orders under the market have become sell orders over the market. Support has become resistance. And the more significant that previous support area was—that is, the more recent and the more trading that took place there—the more potent it now becomes as a resistance area.
All of the factors that created support by the three categories of participants—the longs, the shorts, and the uncommitted—will now function to put a ceiling over prices on subsequent rallies or bounces.
Chart analysis is actually a study of human psychology and the reactions of traders to changing market conditions.