Understanding the psychology within the formation of support and resistance level can help you better understand how and where to trade, says Accendo Markets' head of research.
When trading activity in any asset intensifies at certain price levels, support and resistance can form – like floors and ceilings, some traders like to think. Why this occurs is due to the relative enthusiasm (and psychology) of the buyers and sellers trading at those levels. A good understanding of this concept is imperative for any good CFD or spread betting trader. Before looking at how these levels are generated, it’s important to know that there are five types of market participants.
1) those who are already long;
2) those who are already short;
3) the uncommitted who closed out of a long position;
4) the uncommitted who closed out of a short position;
5) the uncommitted who never had a position and are waiting to make a decision
When prices rise, those traders who are long are happy, sitting on a paper profit. They may choose to add to their position on any pull-backs near their entry point.
Those who are short, however, aren’t happy at all. They feel they should have exited their position earlier. But they hold on, waiting for the price to fall back nearer to their entry point in order to try and get out at the lowest possible price (note: closing a short involves buying shares to return to the lender).
Those who are now uncommitted, who sold out of a long position are unhappy, beating themselves up for not staying with their trade. They don’t want to miss out on the up-move and so look to buy in on dips.
The now-uncommitted who closed out of a short position are happy to have avoided a loss and contemplate reversing their prior trade by going long when the price falls back.
The uncommitted who never had a position, waiting on the sidelines for opportunities, may feel they are missing out and elect to jump in. Like everyone else they look to buy on any dips in order to optimise their entry.
When the price falls back to the five groups’ psychological ‘level’, their cumulative activity can increase demand and push the price up; those desperate to be in the trade and wanting to guarantee execution are prepared to pay a higher price. Should this intervention happen several times, and the price fail to fall below that level, a support level can form.
When a share price falls, those who are long are unhappy. Wanting to get out (sell) at the best price possible, they look to sell on any rally back near their entry point. Those who are short, however, are upbeat with their positions showing a paper profit. They may look to add to their position on any rallies.
The now uncommitted who had long positions are happy to have got out early and weigh up now doing the opposite. The now uncommitted who closed their short position early, however, are kicking themselves and look to short again on any moves higher. The uncommitted on the sidelines may now decide not to wait any longer, and so look to short on any rally.
When the price rallies to everyone’s ‘trigger’ point, the aggregate activity of the group can result in more selling/shorting pressure (traders prepared to sell for less in order to ensure execution) which, if it happens several times, can lead to the formation of a resistance level.
The more that the above occurs at certain levels, the more of a vested interest (bullish or bearish) develops and the more likely that the level will prove supportive/resistant in the future.
If the appetite of one group is ever disturbed (increase or decrease in buying/selling pressure) the level can be broken and the price rise/fall until a new level is found - formed in the same way as discussed above.
The longer a level is tested and remains unbroken, the more significant it, and any breach, becomes. When levels are broken they also typically reverse their role. This is because those who are offside (holding a losing position) will want to exit as close to breakeven as possible while those who missed the boat on the current move will want to enter with the best entry point (any return to the prior level).
Two other elements to be aware of are round numbers which often serve as supportive/resistant with traders using them as psychological targets for entry/exit.
Protective stops can also lead to a lot of orders being automatically executed (losses being cut/profits taken) near a particular level. Knowing where these might be placed (often just below prior lows/above prior highs) can help in know where support and resistance might kick in. Limit orders (orders to open a position at a set price above/below market price) can also contribute in a similar way (the Uncommitted group might use these)
If you can identify which group (1-5) you are part of and which emotion you are experiencing you will see how you can contribute to the formation of these all important support/resistance levels. This can help you better understand how the levels form and where your trade may next encounter a helping hand or face a hurdle.
Michael is head of research at Accendo Markets. After a decade in equity and hedge fund research, he now focuses on market observations and trade ideas for execution-only clients. Tweet @Accendo_Mike
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Warning: Remember, particularly if you are new to trading in the stock market and in forex, that the prices of shares and other investments can fall fast and you may not get back the money you originally invested. The material here is for general information only and is not intended to be relied upon for individual investment decisions. Take independent advice before making such decisions. Also, the BullBearings free stock exchange simulation portfolios are a good way to practice trading techniques.
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