In a previous article we discussed the importance of having price levels you believe in. In this article, we’ll discuss the use of price levels in trading and how to assess the validity of any method of setting levels to trade off.

Setting price levels is seen as an integral part of trading to most traders. There is some process of analysis to define price levels before trading and often price levels will also show themselves as the trading day progresses. Levels are commonly set using an indicator, pivot points, previous support or resistance, volume profiling or any of thousands of other approaches. Setting a price level is just a traders’ way of saying “I expect something to happen at this price”. It gives them an anchor on which to place a trade.

Most commonly, traders are looking for either a reversal or a breakout at their price level. So what would make either of those two things happen? Reversals can occur for a number of reasons.

  • It may be that the price is a target for many traders.  Consider a market moving up to a point where lots of traders have exit orders. Long positions exit their trades by selling which can either halt the move up temporarily or have price move down which other traders see and trade with.
  • Price moves up until we get to the point where nobody wants to buy at what are now considered to be extremely high prices. With a lack of buyers the market will stall and is often enough to cause an imbalance favoring the sell side.
  • Sometimes it is simply that there are lots of sellers waiting to initiate new short positions at what they also consider to be prices too high for the market to bear. 

With reversals, you have both an “initial cause” as well as the more herd-like follow up reaction to the initial move. We can consider breakouts as follows:

  • A breakout in a trending market will occur because basically, nothing changes. We just continued through a price level. Trader behavior remained consistent. In a breakout to the upside, it means buyers keep buying.
  • In a range bound market, a breakout usually starts off with a probe through the top of the range which triggers stop-loss orders that in themselves perpetuate the breakout.

In one of the above cases, the “lack of new buyers” in a move up, the expected move occurs by a relative lack of activity. In another, a breakout occurs because nothing changed at all. In the other cases, you are only going to get the change in price you need if other traders make an active decision to exit their positions or enter new one’s at that specific level.

Some trades will work because nothing changes and some will work because there is a major change in behavior.

With a breakout of a range, we have stops to consider. Stops getting triggered causes a swift and violent reaction and so the payback will be fairly fast IF you are right about the trade. If we are moving to a level we last touched 3 months ago, will there be as many stops the other side of that level compared to a level we last hit 3 hours ago?   Most likely not. The age of the level is also a factor.

For those new to trading, these may be things you’ve never considered. It’s clear that not all levels are equal. Any specific trade doesn’t just require the price to move your way but requires a certain set of behavior from your fellow traders.

A trade that requires a major change in participants’ behavior requires lots of people to react at that price. That can only happen if lots of people are looking at the same price or the same area. Many novice traders start out trying to find a magical combination of indicators that gives them a trigger to trade, trying different indicator settings to find that ‘special’ combination that tells them when to buy and sell. The irony is –the more you combine and customize; the more unique the results become. The more unique the results, the less likely it is that other traders will be looking at the same level and the less likely there will be any reaction.

Given that some price levels require a larger change in trader behavior than others, it follows that these price levels should be visible to the largest number of traders. The more obvious a level is, the more likely other traders will have that area as either a target, stop loss or counter trend orders.

Of course, there is a downside to levels that are obvious. Predatory traders will watch these levels too. A  “head fake” is a common term given to a market that appears to breakout but then falls back into the range. Consider what is going on there:

  • We move up to a level of resistance, reversal traders have their entries there.
  • We push through the level of resistance – reversal traders get stopped out, breakout traders enter the market.
  • We then drop back through the level, breakout traders get stopped out.

This is a “bread and butter” play for predatory traders. The conundrum is that for many trades, we need other people to change their behavior. That means we need our area to be fairly well known. We also know that these well-known areas are likely to be gamed by predatory traders.

Nobody said trading would be easy!

It is without doubt that the most attractive trades to novice traders are reversal trades. Many aspiring traders have a vision of buying at the low of a move and selling at the high; chasing the biggest paying trades. The reality is that with any move – you can have 3 or 4 good candidates for the low of the move and as many for the high of resulting counter-move. By the time you have had 3 failed attempts at catching one of these extremes; you will be playing catch-up and be lucky to break-even as a result of your hard work. There are lots of vendors out there selling “secret” systems for catching these high/low trades but as we have seen, it will take more than a “secret” to turn the market.

Some of the ‘less attractive trades’ (such as breakout/continuation trades), have less potential (in theory) in terms of the size of the move. After all, the market has already moved in that direction and there is only so far it will go. These less attractive trades need less of a change in participant behavior and so it follows they are actually higher probability trades.

The Middle Ground….

It would be somewhat unfair to just throw problems at you without solutions. The first step in resolving an issue, is realizing that it exists. Understand that a full reversal is not possible at a price if only you and 2 other guys know about the level. Sure, you will get lucky sometimes. Overall you will lose if you continually trade against the majority of traders unless you are doing so in areas where many people are looking to change their behavior.

Let’s say you have 3 or 4 candidates for the low of a move or the end of a trend. Price is moving down, you aren’t in position. Why not let other traders do all the heavy lifting? Why not let the market move down and find the level to reverse off and then take a trade to the long side? Your checklist for entering a trade to the long side could be something like this:

  • Market moved down to your levels
  • Market reversed at or close to one of your levels
  • You see a decent sized price swing-up with  good volume in the reversal off that level
  • Now start looking for a long trade

With this approach, you are still using the levels, just in a slightly different way. You are letting other traders get in early and suffer the fake reversals caused by predatory traders.  You can see the market has clearly reversed and that traders in the last “push down” have been stopped out. Now you can make an educated decision as to whether trader behavior really did change as expected at your level. You have both anticipated AND seen the reaction at one of your levels. Now traders’ behavior has changed, it is still early in the move, there is still good potential in the new direction. Any trades you take in this direction are based on trader behavior continuing. You are no longer bucking the trend, no longer taking bets against the herd.

Of course, you cannot catch the whole of the move this way but if you are trading reversals right now and suffering from the high number of losses associated trying to guess the end of a move, this is a great middle-ground.