In markets, we often hear of these precise levels, beyond which everything is said to unravel. The so-called “psychologically important level” or “breaking point.” Their allure is undeniable. If these levels could be relied on then one could fully prepare for it in advance, exiting unscathed before the stampede of the masses.
The power of belief goes some way in explaining why these levels appear to exist. Jonathan Kingsman, in his book “The Sugar Casino”, argues that although individual human beings are irrational and emotional, group behaviour becomes repeatable and predictable. Humans use their experiences of past events to show them how to react to current ones. With enough technical traders with sufficient collective experience of the market, you might get repeatable price patterns.
One argument against relying on these levels and the broader field of technical analysis rests on what its based on – the price. It’s especially hard to put a price on an asset that doesn’t produce income. It’s hard to say what the right price is for a commodity like oil and, thus, when the price is too high or too low. Was it too high at $100-plus? Was it an unsustainable blip? History says “no”: it was that price for 43 consecutive months leading to August 2014. And if it wasn’t too high then, is it too low today? The answer is that you can’t say. Ditto for whether the response of the price of oil to the changes in fundamentals has been appropriate, excessive or insufficient. And if you can’t be confident about what the right price is now, then you can’t be definite about whether the price was correct six months ago, a year ago or ten years ago.
Much as we are told that markets always reflect the collective demand and supply of a particular asset, that isn’t actually true, at least not all of the time. Markets much like wider society are arenas in which the most motivated participant is omnipotent. And this is especially important during periods of sharp reversals or periods of price congestion followed by a break-out.
Psychologically important levels do exist. The question is always do those same levels still exist now? The motivated buyer or seller that drove the price action at that last price level may not be as motivated anymore, he or she may not even be in the market anymore!
This is why positioning analysis is so important. It can offer insights into whose done what in the past, and what happened when they did too much of it and how much positioning then relates to other factors like price, curve structure and fundamentals.