Resistance and Support

This article has been mentioned on a few sites, I saw it first at Free Exchange.

It notes that prices that end in .99 induce customers to purchase a much higher percentage of sales than would be suggested. It is particularly true for lower priced items, but a purchase like a washer/dryer wouldn't have much effect.

While it is easy to design an experiment in a retail setting to test that theory, it would be much more difficult to test it in the financial markets. However, it seems to me that it would most evidently manifest itself in support and resistance points. I don't think support and resistance really translate well into trading systems. However, they can be useful in explaining behavior in the market (though I admit more value in hindsight than at the time). For instance, a stock might test its five year high several times and after breaking through on higher volume, it will surge significantly. A more active trader could see that and place buy stop orders above the resistance level. The problem with using a system is that sometimes it will go slightly above the resistance and then drop significantly. It is done more based on feel and that's also the problem with testing the effects of support and resistance lines using standard statistical techniques. A sustained, high volume move through a resistance point is more important than a weak one.

Getting back to the BBC article, a resistance line can be thought of like a price of 8 euro. The marginal asset manager might think that a stock is worth no more than 25 dollars. He would be interested in selling at 25 and willing to buy at 24.99. However, in the real world, the decision would really be how much of his portfolio to sell at 24.99 vs. 25.00 and not whether he is buying at 24.99. Due to the same effects noted in the BBC article, he would be much more willing to sell at 25 than at 24.99. The situation works in the reverse for a support line at 25, a manager might only be willing to buy a little at 25.01, but he might be willing to buy more at 25. You may ask shouldn't it be 24.99 where he wants to buy more to be consistent with the article? However, the real meat of the article is that people don't react linearly to these price changes, the same way that portfolio managers or traders might react.

There's one problem with this analysis that I can figure out so far, the prices in the BBC article are all small. While the prices of stocks can be reasonable on the face of it, even a retail investor would probably be buying 100 share lots and a PM would purchase significantly more. So the question is, is it the dollar value that matters or the price that matters? I'm not really sure of the answer, but I would say at the very least support and resistance are important enough that every technical trader would pay attention to them. There has to be some "inefficiency" here.

Testing this would be another problem, but I'm sure some finance professor is already looking into it. I really think that the key would be to look at when it comes to resistance points with light volume or heavy volume. For instance, after identifying resistance points, I would calculate whether they are above a moving average of volume to determine whether a day is a light volume or heavy volume day (might want to do relative to the market as a whole as well) and then I would look at how the stock performs relative to the market. I would identify resistance points using something like Average True Range relative to the stock price. For instance, a 6 dollar stock that moves 25 cents a day might have have support or resistance at the $1 level, but Goldman you might look 20 dollars away for support/resistance. That way you can do all the stocks together and then compare quartiles of stocks based on price or trading volume. Finally, all you have to do is look if high volume violations of resistance points or confirmations of support lines result in prices above those points over the next month (or 3) more so than the low volume.

That's probably a publishable paper right there, biggest problem is probably identifying the resistance points. It would make sense to do it in multiple ways to avoid the criticism that you measure it wrong. If you don't remove earnings days or something, you'll also need to make some kind of assumption to deal with them.