Are Support and Resistance Levels Fake?

by

I recently performed an experiment on Excel to determine whether or not stocks follow a random walk.

That is to say, the probability of a stock moving up or down every day, is 50/50 in the short term. And with a positive upward drift in the long term.

Its price is independent of where it was the previous day. Note: This experiment was actually already done by Princeton and in the book A Random Walk Down Wall Street (source: https://en.wikipedia.org/wiki/Random_walk_hypothesis)

If this were true, it would mean that strategies such as Technical Analysis is an illusion. And that technical traders are Captain Hindsights.

The Coin Flip Experiment

To perform this experiment, I used the =RANDBETWEEN() function in Excel, to have it choose a number between 0 and 1. This simulated a coin flip for the experiment.

0 = Tails

1 = Heads

I started with at 0 and then started flipping coins.

If a coin flip turned out heads, I would add +1 to the total and move up the chart 1 space. If tails, I would subtract -1 from the total and move down the chart 1 space.

Then I plotted each point on a chart.

You can easily perform this same experiment on your own using the same method in Excel with your own numbers and runs.

Coin Flip Test Run #1

In my first test run, I flipped a coin 88 times (88 because I randomly copied and pasted the formula down that many rows) and produced the following results:

 

Immediately, we can see that a technical trader will look at this graph and call a support level at the -4 area shown above, which is during coin flips #13 to #38.

They might also say that this coin is “trading within a range” between the -1 to -4 areas during that time.

At coin flip #41, it would have reached the resistance level at -1, and then break through to the top, until it hits resistance again at the +2 and +3 areas, before dropping back down.

Coin Flip Test Run #2

I performed the same experiment again this time, using a million or so coin flips, to get a better sample size (actually, all I did was copy the columns and hit ctrl+D to see how far down the Excel worksheet it would go. This almost crashed my computer.)

This second chart displayed “support” and “resistance” levels much clearer. The first resistance area around the 200 mark. Support area around -300.
Between coin flips 400,000 and 700,000, you can see what a TA trader would call a perfect head and shoulders pattern.
Follow by more resistance a little below 200.
We do come to a problem point where a stock’s price cannot go below 0, and that’s where the Random Walk hypothesis fails. Does that mean that the next coin flip should 100% to the upside? I not 100% convinced it would.

Conclusion

Technical Analysis’ attempt to explain trading and stock movement using market psychology might, in reality, have a random walk element to it. And maybe it is this random walk that explains stock movement a lot better than TA does. If true, using TA might be a naive method if we see stocks moving independently of its previous move.
However, with the TA movement, if every trader believed in it and bought stocks at an inflection point where the TA says to buy, it becomes a self-fulfilling prophecy.
But in that case, that would mean that stocks move based on the illusion of an inflection point, and in actuality, it’s only the result of everyone buying in aggregate.
Which means that stocks can move at any price point if everyone bought it, and not necessarily have to wait for a candlestick to say so.
The fact of the matter is, if you give 5 technicians a stock chart, you’ll get 5 different interpretations in return. And if only some of them are correct, we can’t conclude that technical analysis works.
This might also help explain why there are so many newsletters and trading alert services trying to make money teaching this stuff, when they aren’t successful in trading TA themselves.
(Visited 811 times, 1 visits today)

Leave a Comment