Emotions drive prices in the markets. Well, to be more exact, emotions motivate people to take certain action in the markets. Most traders believe that the hardest thing to do in trading is to learn how to read price properly. The truth is that the hardest thing to do is read ourselves and minimize the effect our emotions have on trading. I’ll leave the higher level discussion to Dr. Woody Johnson, the creator of Online Trading Academy’s Mastering the Mental Game course. I want to discuss a technical phenomenon that is caused largely by human emotion, so that you can recognize it and take advantage of it.
In our Professional Trader Course we teach traders how to properly identify the best zones for entering or exiting trades. These zones are known as supply and demand. The technical level I am discussing is a variation of those levels, but can be very effective in trading the markets.
Have you ever bought a stock at what you thought was a good price because it had been support in the past only to see the stock drop? Remember the emotions that ran through your head at that point. You were nervous (fearful). Most likely you were just hoping that the price would return to your entry zone so that you could sell for break even or just a small loss. It may be somewhat comforting to know that you were not alone. There were likely many other people who bought in the same area and were experiencing the same emotions.
When price returns to the original entry level, you may sell or even try to hold on expecting prices to rise. The other investors/traders will do the same. There will also be traders who profited by shorting the original drop in price and will look to do so again. There is a large group of people who are missing out on this level…the buyers!
Without the buyers to send prices higher, price can do nothing but drop under the strong selling pressure. So in looking at my charts, I like to identify broken demand levels that can potentially become supply.
The opposite is true for broken supply levels. Traders who exited their long positions at that level only to see prices move higher are feeling regret for missing out on higher profits. The short sellers are hoping to exit their losing trades for minimal losses. All of these people will be looking to buy when prices return to the broken supply zone, transforming it to a fresh demand.
I call these levels role reversals. There is some debate as to whether they are as strong as the supply and demand zones we identify in our courses. You can simply wait for additional price confirmation before acting on one of these levels. Make no mistake there is a lot of emotion driving price in any market. Identifying this emotion and its effect on price could give you an edge in your trading.