The Principle of Polarity: Supply & Demand 101

Support is a level in a declining market trend where there is a temporary halt due to more buying pressure than selling pressure. These are the troughs in the market. They are reaction lows where the demand overwhelms the amount of supply. Since there is enough buying pressure here to overcome any selling that there might be at this level, the result is a pause in decline where prices then reverse back up again.

Resistance is the exact opposite of support. Resistance is a level in a rising market where there is so much more selling pressure than buying pressure that there is a temporary halt in the uptrend. These are the Peaks in the market, or reaction highs where supply exceeds demand. Since there is enough selling pressure here to overcome any buying, prices stop rising and reverse back down again. A break above resistance is considered to be bullish while a break below support is considered to be bearish.

In these charts above, you can clearly see where support and resistance come into play. The red dashed lines represent where prices stopped appreciating and for whatever the reason, supply now exceeds demand. Same on the flip side where prices stopped falling and for whatever the reason, demand now exceeds supply at that particular price point. Remember, we do not care "why" prices stopped falling. We are just observing the market proving that this is indeed the fact. One cannot argue that at these resistance levels, there are more sellers than buyers. Same thing on the way down. These support levels are recognizable and are very clear. It is a fact that at these levels, prices stopped going down and reversed up because there is now more demand than supply, for whatever the reason.

The supply and demand principles detailed above, and throughout this post for that matter, can be applied to all liquid assets: stocks, indexes, ETFs, commodity futures, forex, etc. So when we refer to a "market" or a "security", these words are being used to interchangeably describe a liquid free market. These principles can also be applied on various time horizons. You could be looking at a 20 0r 30 year weekly or monthly chart, which many would consider long-term and you could also be analyzing short-term daily charts, or even intraday. The one thing I will say is that the larger/longer the time horizon in question, the more reliable these principles above can be. This is due to the amount of volume taking place at these key turning points. Obviously 20-years of resistance, for example, is going to be much more difficult to penetrate than 20-minutes of resistance on say, an intraday 1-minute chart. Contrary some to popular belief, technical analysis actually works better the larger the time horizon. That myth about technical analysis only for short-term traders is simply a lie.

Now, the added value of recognizing where support and resistance is that they are constantly turning into the other. Former resistance turns into support and former support turns into resistance. This is what we refer to as the Principle of Polarity. From Edwards & Magee almost 70 years ago:

…here is the interesting and the important fact which, curiously enough, many casual chart observers appear never to grasp: these critical price levels constantly switch their roles from Support to Resistance and from Resistance to Support. A former Top, once it has been surpassed, becomes a bottom zone in a subsequent downtrend; and an old Bottom, once it has been penetrated, becomes a Top zone in a later advancing phase

The psychology behind this concept is very interesting and it's important to understand. There is a reason why this works. Let's use the above example of former resistance turning into support. Let's say someone recommends a stock to you and it's at $30 per share. You start watching it slowly creep up $31, $32, $33... and you say to your self, "Damn, if only I had bought it at 30 when I had the chance. Well ultimately the stock gets up to $35 and you're really feeling the frustration. Well, the stock then starts to fall back down after hitting $35. It goes down to $34, $33, $32... and eventually all the way back down to $30, which is where the stock was when you first started to watch it. So what do you do of course? You buy it, because you missed out on a pleasurable experience the last time you had this opportunity and you passed on it.

So, you buy the stock and it starts to rally. You feel like a hero and know you should have done it the first time, but somewhat happy obviously because you're making money. Anyway, the stock you bought at $30 is now starting to approach $35 a few weeks or a few months later. You remember that $35 is the level where it rolled over before and starting falling in price. You would have had an unpleasurable experience had you bought it the first time and not sold it at $35. So of course, you sell it and take the profits. There is market memory in those 2 prices: $30 and $35.

In the meantime, while you are successfully buying a stock at $30 and selling it at $35, there are many others around the world doing similar things for different reasons. Think of yourself as a short seller. In other words, someone who is trying to profit from the stock going down. You first hear about the stock at $35 and begin to watch. It immediately starts to fall $34, $33, $32... and you're frustrated because you didn't short it at $35 when you had the chance. It ultimately gets down to $30 a few weeks or a few months later, and then it starts to rally: $31, $32, $33... and eventually back to $35. You're still upset with yourself for not shorting it at $35, so you obviously put on the trade. You're now short the stock at $35 and just like it did previously, it starts to fall in price: $34, $33, $32...and eventually it reaches $30. Had you shorted it at $35 the first time, you would have wanted to take profits and cover shorts at $30. So of course, you want to have a similar pleasurable experience to what you would have had the first time. Therefore you buy your shares back and cover your short positions. Boom! You've booked a profit.

That buying and selling taking place at $30 and $35 is happening by the buyers, the longs, as well as the sellers, the shorts. But it goes even further. Had you been long the stock at $30 immediately after hearing the idea in the first place you would have made money right away. The stock went straight to $35. The problem, hypothetically, is that you didn't take profits at $35. You bought it at $30, it went to $35, you didn't sell it, and then it fell back down to $30. The entire time the stock was falling $34, $33, $32...you wish you had sold at $35 because you're now watching your profits evaporate. Fortunately, as we later came to learn, the stock rallied back to $35, which gave you a second chance to sell you position for a nice profit.

It works the same way when you're on the wrong side of the trade. Let's say the stock you had originally been recommended was at $35 at the time. You went out and bought it right away, so now you own it. Unfortunately, shortly after you made the purchase, the price of the stock starts to fall: $34, $33, $32...and eventually down to $30. Over the next weeks and months all you wish is that you had never bought that stock in the first place. You can't even think about your winning positions because you're all caught up in this losing trade. You keep saying to yourself,"If it can only get back to where I bought it, I can sell it, and get back all this money I've just lost. Well, luckily the stock bounces from $30 and starts to rally back to where you originally bought it: $31, $32, $33...and eventually back to $35. You are obviously relieved that you could recoup those losses and just sell it so you can pretend it never happened. Your first instinct is to get out so you never have to worry about that pain you just endured ever again.

Sitting through the pain of losing money works the same way on the short side. Let's say you are recommended to sell the stock short at $30 and you immediately pull the trigger to only watch it rally to $35. The pain you're feeling as you watch it creep up $34, $33, $32... is not a pleasurable experience. All you can think about is the stock getting back down to where you originally shorted it so you can buy it back, cover your shorts, and move on from the pain you just felt watching your short rip $5 in your face. As we now know, in hindsight, that stock rallied back to $35 after bouncing at $30. Now that your hopes and dreams have come true, and you're back to even, you're out. You buy your stock back, cover your short and act like it never happened.

It's interesting, psychologically we are more concerned with avoiding pain than we are appreciating success. In other words, not having to take losses is overwhelming more important to us than making money. That's just how we're built as humans. It's a major flaw of ours and is one of many reasons why us humans make terrible investors. Our minds are trained to do the exact opposite of what we should be doing. Fear and greed dominates our emotions at the worst possible moments.

While this is all happening, the volume levels are increasing depending on how many of the above scenarios are taking place in the minds of traders and investors, or algorithms they may have built. While we can never be certain whether former support will turn into resistance, and vice versa, past price behavior can definitely give us increased probability. With that in mind, price movements, whether it's a breakout above former resistance, or support levels breaking and price hitting new lows, will do what it wants. We gather all of the data and use a weight of the evidence approach to defining risk management levels and price targets. The market acknowledging over head supply (resistance), or demand underneath (support), or blowing right past it like it's not even there tells us a lot about the strength, or weakness, in a given market. This is just as important.

The more volume that takes place at or near a specific price, the more important the levels become. This can be measured by using a volume by price chart where you have horizontal lines representing volume overlaid with the security in question plotted using the x and y axis. But after you've been doing this for a while and look at as many charts as a lot of us do, you can just tell where the volume is just by looking at the chart. Therefore, for me, it's not necessary to plot a volume by price indicator because it just clutters the chart for no reason. But for beginners, it's probably not a bad idea to use them.

The point is that there is a lot of memory at specific prices that help us manage risk as well as to know where to take profits. This allows us to calculate a risk vs reward profile for every single liquid asset in the world, from Apple, to Google, to Soybean Futures, to a Singapore ETF, U.S. Treasury Bonds, etc.  Supply and demand dynamics, our own fear and greed, are blind to the asset class. These principles can be applied across the board. They can be seen in markets in the 1800s and can be seen in today's market environment, fed or no fed intervention, yellen or greenspan or bernanke. None of that noise matters to supply and demand. We are all that matter. And while markets evolve over time through technological advances and exchange rules, the one constant is us. That won't change. We drive supply and demand.

The psychology behind this support and resistance levels makes a lot of sense. This is why technical analysis, not only works, but as market participants it would be irresponsible of us to ignore. We see these key levels of supply and demand doing what they do in all sorts of different asset classes on many time frames, long-term, short-term and everything in between. You can see the list at our premium member chart book to get a better idea of my starting point. This is the top/down approach and from this list, we build themes and then work our way down to the individual stock or perhaps a sector ETF. This is both long and short, of course. We have members who are options and futures traders and members who are just stocks and ETFs. Many trade all of them.

I hope this gives you some insight into part of my process. It is the same process that will help me find support and resistance levels regardless of time horizon or market environment. This to me is the best tool in the world to manage risk and define price targets. Click Here to see this process in real time.

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