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Role reversal in Forex – The psychology of support and resistance

Role reversal in Forex – The psychology of support and resistance

The concept of role reversal is one which is hardly ever mentioned in training courses organized for retail forex traders, but we see institutional traders using this concept around support and resistance areas to devastating effect. This article will explain the concept so that retail traders can understand it and use it as well.

What is Role Reversal?

Role reversal is a phenomenon that is applied to resistance and support areas and refers to a situation when a broken resistance becomes a new support, or a broken support becomes a new resistance. This only occurs when the market action has broken a key support/resistance level and experiences a pullback of price on the broken price level. A pullback refers to a situation when price turns after the breakout to attempt to return to where it came from. The role reversal is completed when the broken price level of support or resistance is able to stop the price from returning to its pre-breakout levels.

Role reversal is a direct consequence of the sentimental behavior of the participants in the forex market. This can better be explained in the context of the psychological events that create support and resistance areas.

The Psychology of Support and Resistance

Resistance and support areas do not just occur: they are created as a result of the way market players react to the news and the sentiments that are created as a result. Also, we need to understand that the premise of technical analysis which states that “history repeats itself”, is a powerful motivator for some of the sentiments and actions of market participants.

In any market, participation will be made up of those who are selling, those who are buying, and those on the sidelines (the so-called uncommitted traders). The sellers and buyers are already committed to their respective positions in the market, and can at various times change roles or become uncommitted when they decide to liquidate their positions and stand aside. We also have the uncommitted traders who tend to stand aside and watch for an opportunity. The entrance of these uncommitted traders tends to sway the market as well.

This is how psychology of traders works at a price level to form a resistance. Usually there may be a cluster of buy and sell orders around a price level. If the price of the asset suddenly moves downwards, market participants will respond to this action.

 There are the sellers, who have active sell orders in the market. When price starts to head steeply downwards to put their positions in good profit territory, many of these sellers may regret not placing larger sell orders and may decide to sell more of the asset. But they prefer to do this using limit orders at a higher price level, which allows them to sell again at good prices. This causes a brief lack of selling interest at current price and higher selling interest at a higher price.

 Buyers whose orders had been triggered may realize they have been caught on the wrong end of the market and may also be hoping for a price recovery so they can quickly exit and cut their losses, or perhaps close at breakeven. As prices recover slightly due to previously committed sellers clustering orders around a higher price level, buyers will be willing to meet these orders by closing their positions at those higher levels.

In a situation where the downward price move has broken a support area, sellers will most likely use the support price as a new place to reset new sell orders to add to their existing positions. Also, as buyers exit positions at where these sell orders are located, these actions cause a pullback of price to the broken support area.

 The uncommitted traders who never made up their minds on where to trade initially, may then realize that price will only move south. But they do not want to sell at current price, but also set orders at higher market prices so as to get more profit from their orders. A first group of uncommitted traders respond by selling at the broken support so as to catch the downside move. The other group of uncommitted traders who had setup previous short orders and exited those trades early, then realize that they had exited the market prematurely. Many succumb to the emotional pressure to get back in and they may opt to open new sell orders at the previous broken support.

As the uncommitted traders become committed sellers at the previous broken support, they trigger overwhelming selling interest there. This causes the downward price movement to resume at that area. This is how a downside breakout at support leads to a pullback and a resumption of the downtrend. This causes the previous support to become a new resistance.

The reverse is also the case when upward break of the resistance occurs. Desire by uncommitted traders to buy at lower price levels to maximize gains, addition to existing buy orders by already committed buyers at lower price levels, and exit of existing sell orders by previously committed sellers at lower price levels to reduce their losses, all cause a previously broken resistance to become a support.

The snapshot above shows how role reversal occurs in the financial markets and the sentiment-based actions of all the categories of market participants.

As a trader, you must understand the concept of role reversal so you can maximize fully in order not to leave money on the table when trading. This is actually how limit orders are utilized in the forex market, as these orders usually allow for a price pullback before resumption of the price move in the direction of the breakout.

Summary

In summary, role reversal at a broken support will occur as a result of the following: If prices break below a support (as shown in the snapshot above), buyers will seek a good reaction peak (i.e. upside retracement) to exit. This is at the broken support area. Committed sellers would look for the best price to sell more, and uncommitted traders who were previous committed sellers that closed their positions early would look for a good area to re-enter. This will again be at the broken support. With temporary loss of selling interest at current price and greater selling interest at higher prices, there will be transient price recovery which forms the pullback.

Once price recovery peaks to the broken support, renewed selling interest and lack of buying interest will combine to send prices further downwards. The opposing situation is also seen when there is a break of a resistance.