By Chris Ebert
One quality of the stock market that is universal is that folks tend to buy stocks when the reward appears to be better than the risk. So, simple as it may seem for something as complex as the stock market, there are really only two factors that cause stock prices to move: a change in the perceived reward, or a change in the perception of risk
There is a natural tendency for traders to scan the market for evidence of either increasing reward or increasing risk. Economic developments are often viewed only in terms of whether they are more likely to increase the reward or increase the risk to traders. In simplest terms, traders like to buy stocks when the reward increases, and sell them when the risk increases.
An often-misunderstood quality of the market is that a decrease in reward can be perceived as an increase in risk, just as a decrease in risk can be perceived as in increase in the potential for reward.
Even though the two concepts, risk and reward, are not necessarily linked together, many traders do indeed combine them into a single concept. As such, risk can be viewed, not just as the potential for stock prices to fall, but for the absence of the potential for stock prices to rise; reward, in that light, reward is nothing more than the absence of risk.
Since it is not possible to know in advance the exact nature of future economic news, it is not possible to know whether the market will perceive such news as an increase in reward or an increase in risk. It is, however, possible to pinpoint specific levels on a chart that are likely to represent an absence of reward or an absence of risk.
So, while it will almost always be impossible to know which way the stock market will go tomorrow, because the news is not yet known, a trader can always make some assumptions about what effect the chart will have on stock prices. Essentially, there are always areas on a chart that represent the relative absence of risk and others that represent the absence of reward, and if the news pushes stock prices to one of those levels, it is often possible to predict the end result.
In technical analysis of the stock market, levels of support tend to correlate with a perception of an absence of risk, while levels of resistance tend to correlate with an absence of reward. These levels are not always permanent, and can change rapidly depending on the exact type of analysis. In some instances, a previous resistance level can suddenly become a new support level, and vice versa.
Even though levels can change, as long as a level of support exists there will tend to be a perception of low risk near that level, and when resistance exists traders will see tend to perceive low reward. Thus, it is possible to make a prediction about how traders will react if the stock price reaches either of those levels, even though it is not possible to predict whether either of those levels will actually be reached.
The natural tendency is for traders to sell when prices reach resistance, because resistance represents an area in which the perception of reward typically tends to be low. Just because it’s a tendency doesn’t mean it’s always prudent. That’s because prices sometimes break out above a level of resistance, and the same level that once represented resistance can quickly become a new level of support. What that often entails for traders is that a previous level with a perception of low reward can quickly become a level of perceived high reward. Instead of being a good place to sell, a level of resistance can become a good place to buy – if it gets broken.
But, in the event that resistance does not break, a lot of traders are likely to come to the same conclusion, and they are likely to reach that conclusion at about the same time. Lots of folks will want to (more…)