Support and Resistance – Understanding Market Psychology
Now that we have an understanding of how to identify trends lets understand another basic concept in technical analysis – support and resistance. In general in uptrend prices don’t simply move vertically as prices are always met with resistance. There are always players with opposing views who sell at every uptick. When the selling overcomes the buying the prices move back downwards. Similarly, falling prices are supported in a downtrend by those traders seeking to take profit by squaring shorts or accumulating at lower prices. The point where prices stop falling and reverse direction is called support. Let understand this in more detail.
The price peak at which the uptrend reverses is called a resistance. The prices continue to fall till they reach a point when the buying starts again. Those players who missed out on the initial move and are waiting on the sidelines now take long positions to participate in the up move.
The trough where the prices stop falling and start moving back upwards is called the support. In an uptrend, you will find the supports and resistances at new peaks.
The reverse is true for a downtrend. Prices move down due to selling pressure. However, at lower levels, the prices stop falling due to some buying interest and when the buying overcomes the selling the prices reverse. The lowest point where the prices reverse is called support. In a falling market, the supports and resistances form new lows.
Support and Resistances – How they are formed
There are always three types of players – the shorts, longs, and uncommitted. In an uptrend the longs are the participants who are in the money, the shorts are out of the money and are either waiting for a reversal or possible dips to square their position. The uncommitted are also waiting for these dips to buy. Sometimes the price simply gaps and participants do not get a chance to buy if the rally is very strong. Either way, if the price starts retracing back to either 1/3, 1/2 or 2/3 the shorts start to square, the longs may add to their position and the uncommitted initiate their positions. This starts forming a support for the currency.
Similar psychology works as resistance. The shorts add to their positions on retracements, the longs are looking to exit and the uncommitted are looking to short.
The higher the activity and volumes at a given price level the more important the support and resistance levels.
Some interesting observations that you might experience when determining support and resistances –
- Supports become resistances and resistances become support.
- The more recent the trading activity the stronger the support/resistance.
- Big figures/round numbers act as natural psychological supports and resistances. Therefore do not place orders around these numbers. The market will test them and try to take out the stops.
Next, we take a look trendlines and the best practices for drawing trendlines.