Welcome to our examination of the psychology that drives support and resistance, to cause role reversal. At the end of this, institutional and retail traders will know how too navigate the financial markets, liquidate when necessary, and how to manage their money properly to take advantage of the opportunity. As we do this, check out the forex broker reviews to get the best forex broker for you.
It is not common to find the topics of role reversal fully discussed in forex education material that you find online. However, it is imperative that when you are a retail trader, to understand this concept.
As you learn simple things like how to liquidate or what the financial markets hold in the future, understanding this concept should not be something you skip. Before we go any further, if you are a beginner learning this topic of role reversal, there is one other thing you should not forget.
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Back to role reversal, we find that many of the institutional and retail traders, use the concept all the time. It is effective when applied to the support and resistance area, with great results.
In this article, we are going to try and explain this concept so that institutional and retail traders can learn how to make even better trades.
What Does Role Reversal Mean?
Role reversal is a phenomenon that we apply to support and resistance areas. It refers to the situation when a broken resistance becomes the new support or broken support, becomes the new resistance.
Many of the institutional and retail traders who use technical analysis a lot, hear things like “broken support level is the future area of resistance” or “the previous level of resistance will become the support.”
You might hear all this and wonder why they cannot speak in simple terms. Well, they are speaking in the simplest way possible. After we are done here, institutional and retail traders will be able to use the same concept with ease as well.
It is not uncommon to find even the most experienced institutional and retail traders, not fully understanding this. They might have heard of it, but it is not something that they do.
The role reversal happens when market action has broken the key support/resistance level and then a pullback of the price on the broken level occurs.
The pullback here is a reference to a situation when the price turns after the breakout, to attempt to go back to where it was previously. The role reversal is completed when the broken price level of either the support or the resistance, stops the price from returning to the level it was before it broke.
Let’s Start with the Basics
To fully grasp the role reversal between the support and resistance, we have to get into the basics of these concepts. Support and resistance are terms used by technical analysis institutional and retail traders to talk about specific price levels that have historically been a barrier for institutional and retail traders who want to push the price of an underlying asset in a desired direction.
Let’s have an example to make that clearer.
- Let’s imagine that Amazon stock has attempted to go below the trendline several times in the past few months. However, whenever it approaches the line, it fails to move below it. In such a case, we will call the trendline, the support level.
- It corresponds to a price level where most investors feel comfortable when buying the asset. With that line, the market is prevented from sending prices too low.
- However, institutional and retail traders and others, use resistance to talk about when the price of an asset, finds it difficult to move ABOVE a certain price level. With that, the price of the asset is forced to decline.
Hopefully, that has cleared everything for you. Now, we need to get into the details of these financial market terms.
The Psychology of Support and Resistance For The Institutional and Retail Traders
As we have shown you, the resistance and support areas do not just occur, they are a creation of the way that financial market players react to news and sentiment. The way that they feel about certain stock is what creates the lowest price they are willing to attach to it and the highest that they can go.
When it comes to psychology or sentiment, we understand it to be included in the many variables that make up technical analysis. In previous articles, we have talked about how forex technical analysis looks at just the price.
As a retail trader, you will find that in technical analysis, the sentiment or psychology facet, is built on one truth “history tends to repeat itself.”
Knowing that, you will not have any trouble understanding what motivates the thinking that creates the support and resistance levels, how they break and how you can take advantage of that.
In any of the financial markets, the participants are:
- Those willing to sell
- Those willing to buy
- Those on the sidelines (also called uncommitted traders)
The sellers and the buyers are already committed and in position, in the market. They can sometimes change their roles or become uncommitted, when they make a decision to liquidate their positions.
As for the uncommitted institutional and retail traders, they just stand aside and watch, waiting for opportunity so they can move in to strike. When they enter the market, it will sway.
How the Psychology Works
Usually, we have a cluster of buy and sell orders around the price level at any given time. If the price of the asset suddenly takes a plunge, the market participants will respond to that reaction in the following ways:
1. Active Sellers React
The sellers, who are active and have an active sell orders in the market will react like this. When the price starts to go down, many sellers may regret not making larger sell order because now, their positions are in good profit territory.
They might decide to sell more of the asset. They will most likely do so with the use of limit orders, at a higher price level. This tactic allows them to sell again at good prices.
This action causes a temporary lack of selling interest at the current price and higher selling interests at a higher price
2. Active Buyers React
The buyers whose order get triggered, may realize that they are on the wrong side of the market and may hope that the prices recover quickly so they can exit and cut their losses, or try to breakeven.
As the prices find their footing again due to clustering of the sellers’ orders at the high price levels, buyers become willing to meet the orders. They do this by closing their positions at those high levels.
If the situation is such that the downward price move has broken the support area, most of the sellers will use the support price as the new place to reset their new sell orders and add more to their active positions.
As the buyers exit the position where the sell orders are set, these actions cause the pullback of the price to the broken support area.
3. Uncommitted Institutional and retail traders React
The uncommitted institutional and retail traders who never made a decision on where to trade, may see the opportunity to of the price moving only south. However, they do not want to sell at the current price. So, they set the order at higher market prices so as to get more profit from the orders they make.
The first group of uncommitted institutional and retail traders will respond by selling at the broken support, to get the downside move as it starts. The others uncommitted institutional and retail traders who set up their short orders and left the market, might realize that they left too early.
Many of them then proceed to bow to emotion and get back in and offer new sell orders at the previous broken support.
Where The Role Reversal Happens
As the uncommitted institutional and retail traders now start to be committed sellers at the previous broken support, they cause an overwhelming selling interest. With that, the downward price movement, resumes at that area.
That is how a downside breakout at the support, becomes a pullback and a resumption of the downward trend. This is the role reversal that causes the previous support to become the new resistance.
The role reversal is also what happens when the upward break of the resistance occurs. The following things also cause the previously broken resistance, to become a support:
- A desire by the uncommitted institutional and retail traders to buy at the lower price levels for more profits
- An addition to existing buy orders by the already committed buyers at lower levels
- Exit of existing sell orders by the previously committed sellers at lower price levels to reduce losses
With these, the effect is complete. The financial markets’ sentimental side shows in this manner. As a trader, you need to understand this concept of role reversal so you can fully maximize the order not to leave money on the table when you can have more.
Do The Role Reversal Happen?
It is not uncommon to find institutional and retail traders asking whether this really happens. In theory, on a page, it seems plausible but also very contrived. However, the truth is that, role reversal happen, even on the biggest names of the stock market like Walmart, ExxonMobil, and even the famous Dow Jones Industrial Average.
What most institutional and retail traders fail to understand is, what happens when the price of an underlying asset moves beyond one of the critical support or resistance levels.
There are several critics who do not believe that something like this could possibly happen but it has happened and happens, even to the biggest names in the industry. Nothing is set in stone.
An Application of Support and Resistance
Knowing where the support and resistance levels are, can help you know how and where to set a stop loss. This is a real-world application of the phenomenon. Even though the role reversal may seem far-fetched, it does happen.
Example of how to set the stop loss: Let’s say that you look at a chart and you see the EUR/USD pair is trading above the falling trend line, you might consider this chance, a good breakout trade setup and make the decision to go long.
It is also very sensible to set the stops below the trend lines and support areas. If the financial markets move into these areas, it means that the trend lines that were not supported by the buyers and the sellers, have all the control now.
If you had a trade idea from this situation, it has now become invalidated and you should accept the loss and exit the trade.
Let’s assume that you take another look at the EUR/USD and you see that it has been trending down. In the event that the price has hit the falling trendlines a few times, we take that to be the resistance level.
You will be better off placing a short order right at the downtrend line.
Now, where would you place your ‘STOP LOSS’. The best place to do it, is above the resistance area or falling trendline.
The trade is set in motion, while the trendline holds as price and resistance falls. You have managed to hit the profit target. The second profit target, you did not hit. You missed it by a single pip. However, by that time, you have moved the stop loss to breakeven (that is where you entered the short) and that means you did not lose anything.
This is just one example of how you can use resistance as a guide that points where you place the stop instead of using static or fixed numbers.
To summarize, the role reversal at a broken support will occur when the following things happen: when the prices break below a support, buyers seek the good reaction peak (the upside retracement) to exit the financial markets.
This happens at the broken support area. The committed sellers look for the best price to sell more and uncommitted institutional and retail traders (who were previous committed sellers). These would be the ones who close their positions prematurely.
They will look for a good area to return back into the market. Usually, this happens at the broken support. With the temporary loss of selling interest at current price and greater selling interest at higher prices, we arrive at a transient price recovery, which creates the pullback.
Once the price recovery peaks to the broken support, there is a renewed selling interest and lack of buying interest. Together, they combine to make the prices go even further down. The situation is reversed when there is a break of resistance.
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