The Psychology of Support and Resistance

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Introduction

Support and resistance levels are largely shaped by traders emotions.  In a market, traders are either wanting prices to rise, fall, or are waiting on the side lines awaiting their chance.  So, traders are looking at these levels to gauge entry and exit points for their trades.

As price rises from a support level, the traders who are long are happy and may consider adding to their positions if price drops back down to the same support level. The traders who are short in this situation are beginning to question their positions, and may be thinking of exiting their position. The traders who did not enter the market previously at this price level, may be ready to pounce and go long, as support has confirmed twice. In essence, a large number of traders may be eagerly waiting to buy at this level, adding to its strength as an area of support. If all these participants do buy at this level, price will likely rebound from the support once again.

Price can, however, fall right through the support level. As price continues to drop, traders will quickly realize that the support level is not holding. The long traders may wait for price to climb back up to the previous support level, which will now act as resistance, to exit their trades in the hopes of limiting their losses. The short traders are now happy and may consider adding to their positions, if price revisits the price level. Lastly, the traders who did not enter the market yet may go short, in anticipation of price dropping further. Again, a large number of traders may be ready to make a move at this level, but now instead of buying, they will be selling. This same behavior can be witnessed in reverse with traders' reactions to resistance levels.

As we've already seen in Module 1, support and resistance can be the same thing at different times.  Support can become resistance and resistance can become support as the market moves in time.  This can happen horizontally, in trending channels or with moving averages.  This happens because human emotions and a herd instinct are driving the price movement.  The below chart shows support in Aug and Sep becoming Resistance from Nov onwards.  Look also how price is drawn to the top support/resistance line like a magnet. This re-test of support or resistance is often a good area to enter a trade, as the re-test is confirmation that the supply/demand dynamic has changed, for now, at least... For more on the relationship between price, supply and demand click here.

The Collective Conditioned Response to Support and Resistance

Traders can collectively experience a conditioned response. The below chart, shows how previous price peaks and troughs formed resistance and support in a range. Let's look at the green support line.  Traders who had studied this chart in January, and drawn a trend line connecting the troughs in Oct and Dec, would have expected this support in the future.  Indeed, this is what happened in Feb, as price met the trend lines path.  The same can be said for the red line.  Similarly, this "collectiveness" will happen with a trending support or resistance line, or with moving averages and Fibonacci retracements.

Example - Collective Anticipation of Support and Resistance 

Other support and resistance levels that are influenced by human emotion include round numbers and historic events such as 52-week highs and new market highs. Traders and investors tend to gravitate to these psychological price levels for several reasons. One is that these prices have been significant in the past and traders know they are likely to be again. If a support level worked in the past, the trader may assume that it will provide solid support again, like 5000 in the FTSE 100 or 1200 in the S&P 500

Another reason that emotional price levels are significant is they attract a lot of attention and create anticipation, which can lead to increased volume as more traders get ready to respond. New market highs, for example, create a buzz of excitement as traders imagine price going higher, with no previous resistance levels to slow it down. As the bulls take charge, the euphoria can result in a significant push above the previous high, typically with increased market participation, until the enthusiasm wanes and a new resistance level is established.

A Trader's Perspective of Trading S & R

Reactions are important when trading support/resistance

Identifying Support and Resistance is fairly straight forward enough to do on all chart timeframes IMHO. The key is the price reaction at those areas. At it's simplest anytime there's a rally the base of the rally can be called Support on the chart, Buyers supported that area by buying. Vice versa for selling. The more times the support/resistance area is retested the more valid your support/resistance is. Please note that I see Support/Resistance as areas and not one price.

I find the harder part to my trading is to know how to trade that support/resistance. There's always the old chestnut of "Buy at Support and Sell at Resistance" but you never really know if it's support until after you've bought and there's also the chance that support won't be fully tested so you're not in a position to buy. Maybe It should read "Buy at or near Old Support and Sell at or near Old Resistance" but I do believe that it's the best place to buy or sell as it gives me natural areas in which to place stops i.e. under said support if buying.

To help get a feel for market direction I look at the price reaction at those support/resistance areas that I've identified. If I see the market go up 70 points in 2 days from the support area and at resistance only goes down 20 points in 3 days. I'd say that demand was present at support but didn't see supply present itself in such a fashion at resistance. Therefore my outlook for that timeframe would be more bullish than bearish. I would feel more comfortable buying at/near support than selling at/near resistance. I also find that timeframes are very important to my trading as what often appears to be a major support area on a daily chart might be nothing more than a correction on a weekly/yearly chart. The longer term support/resistance areas are most important to my trading. e.g. Support on a 5 minute chart is nowhere near as important as on a yearly chart. If support/resistance areas tie up on more than one timeframe then you have a tradable market IMHO. For each timeframe I decide whether I'm Bullish, Neutral or Bearish and it's often the case that I'm Bullish on the weekly chart and Bearish on the daily chart for the same equity.

I personally find that once the resistance area is broken a very profitable area to enter long is at the retest of that old area, hence the adage "Old resistance becomes new support" and vice versa for Resistance. There's a number of questions that need to be answered when I trade off support/resistance and as with anything the more I trade the better/more confident I get at answering them. I'd also say that my approach is very subjective and I have to make many "Judgement Calls" on what I see around the support/resistance areas. I would love to find a non-subjective system but have yet come across anything which does not require the trader to use his/her judgment when deciding to buy/sell.

I hope this helps, Dan



To Sum UP

Support and resistance zones are utilized by technical analysts to study past prices and predict future market moves. These zones can be drawn using simple technical analysis tools, like horizontal lines or up/down trendlines, or by applying more advanced indicators, such as Fibonacci Retracements. Market psychology plays a major role in a given instrument's price movement as traders and investors remember the past, react to changing conditions and anticipate future market movement.


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Introduction

Support and resistance levels are largely shaped by traders emotions.  In a market, traders are either wanting prices to rise, fall, or are waiting on the side lines awaiting their chance.  So, traders are looking at these levels to gauge entry and exit points for their trades.

As price rises from a support level, the traders who are long are happy and may consider adding to their positions if price drops back down to the same support level. The traders who are short in this situation are beginning to question their positions, and may be thinking of exiting their position. The traders who did not enter the market previously at this price level, may be ready to pounce and go long, as support has confirmed twice. In essence, a large number of traders may be eagerly waiting to buy at this level, adding to its strength as an area of support. If all these participants do buy at this level, price will likely rebound from the support once again.

Price can, however, fall right through the support level. As price continues to drop, traders will quickly realize that the support level is not holding. The long traders may wait for price to climb back up to the previous support level, which will now act as resistance, to exit their trades in the hopes of limiting their losses. The short traders are now happy and may consider adding to their positions, if price revisits the price level. Lastly, the traders who did not enter the market yet may go short, in anticipation of price dropping further. Again, a large number of traders may be ready to make a move at this level, but now instead of buying, they will be selling. This same behavior can be witnessed in reverse with traders' reactions to resistance levels.

As we've already seen in Module 1, support and resistance can be the same thing at different times.  Support can become resistance and resistance can become support as the market moves in time.  This can happen horizontally, in trending channels or with moving averages.  This happens because human emotions and a herd instinct are driving the price movement.  The below chart shows support in Aug and Sep becoming Resistance from Nov onwards.  Look also how price is drawn to the top support/resistance line like a magnet. This re-test of support or resistance is often a good area to enter a trade, as the re-test is confirmation that the supply/demand dynamic has changed, for now, at least... For more on the relationship between price, supply and demand click here.

The Collective Conditioned Response to Support and Resistance

Traders can collectively experience a conditioned response. The below chart, shows how previous price peaks and troughs formed resistance and support in a range. Let's look at the green support line.  Traders who had studied this chart in January, and drawn a trend line connecting the troughs in Oct and Dec, would have expected this support in the future.  Indeed, this is what happened in Feb, as price met the trend lines path.  The same can be said for the red line.  Similarly, this "collectiveness" will happen with a trending support or resistance line, or with moving averages and Fibonacci retracements.

Example - Collective Anticipation of Support and Resistance 

Other support and resistance levels that are influenced by human emotion include round numbers and historic events such as 52-week highs and new market highs. Traders and investors tend to gravitate to these psychological price levels for several reasons. One is that these prices have been significant in the past and traders know they are likely to be again. If a support level worked in the past, the trader may assume that it will provide solid support again, like 5000 in the FTSE 100 or 1200 in the S&P 500

Another reason that emotional price levels are significant is they attract a lot of attention and create anticipation, which can lead to increased volume as more traders get ready to respond. New market highs, for example, create a buzz of excitement as traders imagine price going higher, with no previous resistance levels to slow it down. As the bulls take charge, the euphoria can result in a significant push above the previous high, typically with increased market participation, until the enthusiasm wanes and a new resistance level is established.

A Trader's Perspective of Trading S & R

Reactions are important when trading support/resistance

Identifying Support and Resistance is fairly straight forward enough to do on all chart timeframes IMHO. The key is the price reaction at those areas. At it's simplest anytime there's a rally the base of the rally can be called Support on the chart, Buyers supported that area by buying. Vice versa for selling. The more times the support/resistance area is retested the more valid your support/resistance is. Please note that I see Support/Resistance as areas and not one price.

I find the harder part to my trading is to know how to trade that support/resistance. There's always the old chestnut of "Buy at Support and Sell at Resistance" but you never really know if it's support until after you've bought and there's also the chance that support won't be fully tested so you're not in a position to buy. Maybe It should read "Buy at or near Old Support and Sell at or near Old Resistance" but I do believe that it's the best place to buy or sell as it gives me natural areas in which to place stops i.e. under said support if buying.

To help get a feel for market direction I look at the price reaction at those support/resistance areas that I've identified. If I see the market go up 70 points in 2 days from the support area and at resistance only goes down 20 points in 3 days. I'd say that demand was present at support but didn't see supply present itself in such a fashion at resistance. Therefore my outlook for that timeframe would be more bullish than bearish. I would feel more comfortable buying at/near support than selling at/near resistance. I also find that timeframes are very important to my trading as what often appears to be a major support area on a daily chart might be nothing more than a correction on a weekly/yearly chart. The longer term support/resistance areas are most important to my trading. e.g. Support on a 5 minute chart is nowhere near as important as on a yearly chart. If support/resistance areas tie up on more than one timeframe then you have a tradable market IMHO. For each timeframe I decide whether I'm Bullish, Neutral or Bearish and it's often the case that I'm Bullish on the weekly chart and Bearish on the daily chart for the same equity.

I personally find that once the resistance area is broken a very profitable area to enter long is at the retest of that old area, hence the adage "Old resistance becomes new support" and vice versa for Resistance. There's a number of questions that need to be answered when I trade off support/resistance and as with anything the more I trade the better/more confident I get at answering them. I'd also say that my approach is very subjective and I have to make many "Judgement Calls" on what I see around the support/resistance areas. I would love to find a non-subjective system but have yet come across anything which does not require the trader to use his/her judgment when deciding to buy/sell.

I hope this helps, Dan



To Sum UP

Support and resistance zones are utilized by technical analysts to study past prices and predict future market moves. These zones can be drawn using simple technical analysis tools, like horizontal lines or up/down trendlines, or by applying more advanced indicators, such as Fibonacci Retracements. Market psychology plays a major role in a given instrument's price movement as traders and investors remember the past, react to changing conditions and anticipate future market movement.


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