In the world of trading, support and resistance are crucial concepts that traders use to determine the direction of price movement. Support refers to a level at which the price of a security tends to stop falling, while resistance refers to a level at which the price tends to stop rising. These levels are usually determined by technical indicators, such as moving averages, trend lines, and Fibonacci retracements. However, there is another aspect to support and resistance that is often overlooked by traders – the psychological element.
The Psychology Behind Support and Resistance-
When looking at a financial market, there are typically three types of participants at any given price level:
- those who are long and waiting for the price to rise (#1),
- those who are short and hoping the price will fall (#2), and
- those who have not yet decided which way to trade and remain on the sidelines (#3).
If the price rises from a support level, traders who are long (#1) are happy and may add to their positions if the price drops back down to the same support level. Traders who are short (#2) in this situation are beginning to question their positions and may buy to cover (exit the position) to get out at or near breakeven if the price reaches the support level again. Traders who did not enter the market previously at this price level (#3) may be ready to go long (#1) if the price comes back down to the support level, creating a lot of demand and adding to its strength as an area of support. This can cause the price to rebound from the support once again.
However, the price can fall right through the support level. As the price continues to drop, traders will quickly realize that the support level is not holding. Long traders (#1) may wait for the 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. Short traders (#2) are now happy and may consider adding to their positions if the price revisits the price level. Traders who did not enter the market yet (#3) may go short (#2) if the price comes back to the previous support level, in anticipation of prices dropping further. This same behavior can be witnessed in reverse with traders’ reactions to resistance levels.
Let’s say that a stock has a strong support level at ₹3,500. Traders who are long (#1) the stock are happy when the price rises above this level, but may consider adding to their positions if the price drops back down to ₹3,500. Traders who are short (#2) the stock may begin to question their positions if the price reaches ₹3,500 again and may buy to cover (exit the position) to get out at or near breakeven. Traders who did not enter the market previously at this price level (#3) may be ready to go long (#1) if the price comes back down to ₹3,500. If a large number of traders buy at this level, it adds to its strength as an area of support.
However, if the price falls right through the support level at ₹3,500, traders will quickly realize that the support level is not holding. Long traders (#1) may wait for the 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 (#2) are now happy and may consider adding to their positions if the price revisits the ₹3,500 price level. Lastly, traders who did not enter the market yet (#3) may go short (#2) if the price comes back to the previous support level, in anticipation of prices dropping further.
Let’s say that a currency pair has a strong resistance level at ₹90. Traders who are short (#2) the currency pair are happy when the price falls below this level, but may consider adding to their positions if the price rises back up to ₹90. Traders who are long (#1) the currency pair may begin to question their positions if the price reaches ₹90 again and may sell to get out at or near breakeven
What are Psychological Support and Resistance?
Psychological support and resistance are levels where traders and investors tend to buy or sell a stock or asset based on their emotions and beliefs rather than on technical analysis. These levels are usually based on round numbers, such as Rs10, Rs 50, Rs 100, or other significant levels, such as all-time highs or lows.
For example, if a stock trades at Rs 99, the psychological Resistance level would be Rs 100, as traders and investors tend to place buy orders at round numbers. Conversely, if a stock trades at Rs 102, the psychological Support level would be Rs 100, as traders and investors tend to place sell orders at round numbers.
Psychological support and resistance levels can be powerful tools in technical analysis, as they can provide insights into the behavior of market participants and help identify potential buying and selling opportunities. Psychological support and resistance levels are not necessarily based on fundamental factors or market trends, but rather on the collective perception and sentiment of traders and investors.
These levels can be influenced by various factors, including news events, market volatility, and economic data releases. One of the key advantages of using psychological support and resistance levels in technical analysis is that they can be relatively easy to identify. Traders and investors can simply look at a stock chart and identify the round numbers or significant levels where buying or selling activity has occurred in the past.
Psychological support and resistance lines occur not because of the perceived importance of a particular technical level. Humans are naturally attracted to whole numbers.
In addition to whole numbers, we also gravitate to round numbers that end in 0, and for lower-priced stocks, 25 or 50 paisa increments.
Below gives you an indication of how this works.
Stocks Below 100
Rupees 50 paisa increments and 1 Rupee Increments Rs. 5.00, Rs. 10.00, Rs. 15.00, Rs. 20.00, Rs. 25.00, Rs. 30.00, Rs. 35.00, Rs. 40.00, Rs. 50.00, Rs. 60.00, Rs. 70.00, Rs. 80.00, Rs. 90.00, Rs. 100.00
Stocks Above 100 Rupees
Rs. 50 and Rs. 100 Rupee Increments Rs. 150.00, Rs. 200.00, Rs. 250.00, Rs. 300.00, Rs. 350.00, Rs. 400.00, Rs. 450.00, Rs. 500.00, Rs. 600.00, Rs. 700.00, Rs. 800.00, Rs. 900.00, Rs. 1000.00
Stocks Above 1000 Rupees
Rs. 250 and Rs. 500 Rupee Increments Rs. 1500.00, Rs. 2000.00, Rs. 2500.00, Rs. 3000.00, Rs. 3500.00, Rs. 4000.00, Rs. 4500.00, Rs. 5000.00, Rs. 6000.00, Rs. 7000.00, Rs. 8000.00, Rs. 9000.00, Rs. 10000.00
Stocks Above 5000 Rupees
Rs. 1000 and Rs. 2000 Rupee Increments Rs. 15000.00, Rs. 20000.00, Rs. 25000.00, Rs. 30000.00, Rs. 35000.00, Rs. 40000.00, Rs. 45000.00, Rs. 50000.00, Rs. 60000.00, Rs. 70000.00, Rs. 80000.00, Rs. 90000.00, Rs. 100000.00
Do you see any patterns?
Beyond the increments increasing in size as you go higher in price when the price ends in 0 and 5, it’s an area where traders look to book profits.
The Psychology Behind Psychological Support and Resistance Levels
The stock market can be an unpredictable and volatile place, with prices fluctuating constantly based on a wide variety of factors. However, one common phenomenon that many investors have observed is the existence of psychological support and resistance levels. These levels can play a significant role in shaping the direction of prices, and understanding the psychology behind them is essential for investors who want to make informed decisions.
1. Human psychology favors round numbers:
One of the key factors behind psychological support and resistance levels is the way that our brains process numbers. As humans, we tend to simplify things and round numbers make it easier for our brains to process information. This is why marketers often use prices that end in 99 or 95, as it makes the product appear cheaper to consumers. Similarly, in the stock market, investors may see a stock or index trading at a round number like Rs100 as a psychological price point and decide to sell, which can create a resistance level. Conversely, if the price drops below a round number, investors may see it as a buying opportunity and start buying, creating a support level.
2. Round numbers become psychological price points:
Another reason why psychological support and resistance levels exist in the stock market is that big round numbers like Rs 100 or Rs 10,000 become psychological price points that investors focus on. When the price of a stock or index reaches these levels, investors may see it as a signal to either buy or sell. This can create a self-fulfilling prophecy, where investors collectively push the price up or down simply because they believe it will happen.
Example, in the Indian stock market, the Nifty 50 index is a popular benchmark index that is closely watched by investors. In March 2021, the Nifty 50 index crossed the 15,000 mark for the first time, which was a significant psychological price point for investors. Many investors saw this as a signal to buy more stocks, pushing the index up further. However, once the index crossed 15,000, some investors started selling their holdings, believing that the index had reached a fair value and that it was time to take profits. This selling pressure created a resistance level at 15,000, which the index struggled to break through for several weeks.
3. Self-fulfilling prophecy:
This self-fulfilling prophecy can be seen in action when investors believe that a stock will reach a certain price. They may start buying it, pushing the price up and making their prediction come true. This can also work in the opposite direction, where investors may sell a stock if it reaches a certain price, pushing the price down further.
Example- Suppose a stock is trading at INR 99 and investors believe that it will reach INR 100 soon. As a result, many investors may start buying the stock, causing the price to increase and eventually reach INR 100. This can then reinforce the belief among investors that the stock will continue to rise, leading to even more buying and a further increase in price. This self-fulfilling prophecy can continue until the price reaches a point where investors start selling, creating a resistance level.
4. Media coverage:
The media also plays a role in perpetuating this phenomenon by focusing on these big round numbers and creating hype around them. This can lead to investors making irrational decisions based on the emotional response created by the media coverage, rather than on a rational analysis of the company or market in question.
An example of media coverage influencing investor behavior can be seen during the Indian stock market’s recent bull run. In early 2021, when the Sensex index reached the 50,000 mark, it received a lot of media attention, with news outlets predicting that the index would soon cross the 60,000 mark. As a result, many retail investors, influenced by this hype, started buying stocks aggressively, leading to a surge in the market. However, when the index failed to cross the 60,000 mark and started correcting, many of these investors faced significant losses, highlighting the dangers of making investment decisions based on media hype rather than rational analysis.
How to Identify Psychological Support and Resistance
Identifying psychological support and resistance levels is relatively straightforward. Here are the steps to follow:
Step 1: Look at the historical price chart of the asset you are interested in trading.
Step 2: Identify any horizontal support or resistance levels that have been previously established on the chart.
Step 3: Look for any round numbers that are near these horizontal support or resistance levels.
Step 4: Pay attention to how the asset behaves when it reaches these round numbers. Does it bounce off the level and reverse course, or does it break through and continue moving in the same direction?
Step 5: If the asset appears to be reacting to the round number, then it is likely that the round number is acting as a psychological support or resistance level.
Step 6: Draw a horizontal line at the level of the round number, and label it as the psychological support or resistance level.