Sceptics may suggest that support or resistance levels can just as easily be randomly picked. The evidence however does not support such scepticism. Indeed, on the contrary, both academic and institutional research suggests exchange rate trends are interrupted or reversed at published support and resistance levels much more frequently than is the case at randomly picked levels. Such levels are therefore seen as statistically important, most likely because of the clustering effect mentioned earlier. Customer orders are placed just above or just below previous highs or lows. As a result, this clustering can have the effect either of pausing or accelerating the short-term price trend at any one time. This link between capital flows and technical chart levels can be expressed in the following way:
“Support” reflects a concentration of demand sufficient to pause the prevailing trend
“Resistance” equally reflects a similar concentration of supply
However, this clustering effect on prices can be further broken down into two specific types of customer order:
Take profit
Stop loss
There are important differences in the way that these two specific types of customer order tend to cluster. For instance, take profit orders tend to cluster in front of important support or resistance levels and thus tend to have the habit of causing the trend to reverse — thus reinforcing that support or resistance — if they are sufficient in number. By contrast, stop loss orders tend to be clustered behind important support or resistance levels, thus accelerating and intensifying the prevailing trend if triggered. Academic research has found that take profit and stop loss customer orders, which impose some degree of conditionality on the order, can make up between 10 and 15% of total order flow. As a result, they can have an important effect on trading conditions and therefore on price patterns. During calm market conditions, they can further restrict price action. Conversely, during volatile market conditions, they can exacerbate price volatility when such orders are triggered. Thus, both in calm and volatile market conditions, they re-emphasize the original importance of the support and resistance levels.
So far, we have been looking at “spot” foreign exchange orders, that is conditional customer orders to be executed for spot (T + 2) delivery. However, conditional orders left in the options market can also impact spot currency price action. More specifically, “knock-in” and “knock-out” levels for exotic options, allowing a client to be knocked-in to the underlying structure or conversely knocked-out of it, can and do trigger specific spot currency price activity. Knock-in and knock-out levels are usually chosen based on previously important highs and lows. In other words, they are chosen based on technical support or resistance levels. As a result, there can be — and frequently is — both spot and option customer order clustering around such levels, further impacting price action.
It is not only customers that place conditional orders in the market. In order to limit a bank’s balance sheet exposure to overnight price swings in exchange rates, interbank dealers either close out their positions at the end of the day or alternatively themselves leave take profit or stop loss orders with their dealing counterparts within the bank in the next time zone. Thus, a dealer in Singapore may pass on their customers’ conditional orders as well as their own to London and London may in turn pass on such orders to New York and so on round the time zones, either until such orders are filled or conversely are cancelled. If there is a self-fulfilling aspect to this whole idea, it concerns therefore the very microstructure of the currency market itself. Broadly speaking, currency interbank dealers follow technical analysis more closely than the customer base of the bank, in part because they have a much shorter time frame than their customers and in part because they have to trade in order to make a living irrespective of whether or not there have been changes in economic fundamentals. Currency interbank dealers and short-term traders follow technical analysis, and because they make up the majority of currency market participants the levels and types of analysis that they follow automatically become important. Thus, structural aspects within the currency market may help explain to some degree the success of technical analysis. What it does not explain however is the superior degree of that success relative to classic economic analysis or alternatively to random walk theory in predicting short-term exchange rate moves. Given that take profit orders cause price trends to pause, while stop loss orders extend such trends, the logical conclusion is that the balance between such orders in the market place is an important real-time determinant of exchange rates.