Technical analysts use support and resistance levels to identify price points on a chart where the probabilities favor a pause, or reversal, of a prevailing trend. Support occurs where a downtrend is expected to pause, due to a concentration of demand. Resistance occurs where an uptrend is expected to pause temporarily, due to a concentration of supply.

These levels, while they may appear arbitrary at first sight, are based on market sentiment and anchoring. Here, we examine how support and resistance zones are largely shaped by human emotion and psychology.

Key Takeaways

  • The concepts of trading level support and resistance important price levels on charts that tend to act as barriers, preventing the price of an asset from getting pushed in a certain direction.
  • Market psychology plays a major role as traders and investors remember the past and react to changing conditions to anticipate future market movement.
  • Shifting zones of resistance and support can be revealed by understanding the sentiment and emotion of individual market actors and how that aggregates up to the market.

The Psychology Behind Support and Resistance

In a given financial market, there are typically three types of participants at any given price level:

  1. Those who are long and waiting for the price to rise
  2. Those who are short and hoping the price will fall
  3. Those who have not yet decided which way to trade and remain on the sidelines

As the price rises from a support level, the traders who are long are happy and may consider adding to their positions if the 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 buy to cover (exit the position) to get out at, or near, breakeven if the price reaches the support level again. The traders who did not enter the market previously at this price level may be ready to pounce and go long if the price comes back down to the support level. 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, the 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 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 are now happy and may consider adding to their positions if the price revisits the price level. Lastly, the traders who did not enter the market yet may go short if the price comes back to the previous support level, in anticipation of prices 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.

Examples of Shifting Zones

These examples illustrate an important technical analysis principle: That which previously acted as support will eventually become resistant. Conversely, levels that formed resistance will act as support, once the price breaks above the resistance level. This can be seen on any chart or any time frame. Though investors commonly refer to daily charts to determine areas of support and resistance, smaller time frames are also used, especially by short-term traders, to establish these areas.

The chart below, for example, indicates the weekly candlestick price chart of Montreal Trucking Company. As the blue horizontal line shows, there is resistance at $15, preventing the price from rising above that level. There also appears to be support at $7.

Resistance

Image by Julie Bang © Investopedia 2019

Support and resistance zones are not only seen at particular prices; they can vary along with upward or downward trendlines.

Human Emotions and Behavior

Fear, greed, and herd instinct are terms that crop up when discussing the psychology behind financial markets. This is because human emotions play a part in the price action observed in markets. A price chart, then, can be thought of as a timeline of optimism and pessimism. Price charts illustrate how market participants react to changing future expectations.

Fear and greed, for example, are seen in the market participants' behavior outlined above. As price falls back to a support level, the traders who are already long will add to positions to make more money. Meanwhile, the traders who are short will buy to cover, because they are afraid of losing money. Herd instinct is also demonstrated in this example as traders tend to congregate near these support and resistance levels, further strengthening them.

Traders can also collectively experience a conditioned response, of sorts due to what is known as anchoring. Anchoring is a heuristic revealed by behavioral finance that describes the subconscious use of irrelevant information, such as the purchase price of a security, as a fixed reference point (or anchor) for making subsequent decisions about that security. Therefore, if a resistance or support level has been established in the past, it can create a shared anchor where those same levels will be met with resistance or support in the future. The figure below shows a daily chart of pharmaceutical maker Eli Lilly (NYSE:LLY), indicating two previous price peaks formed resistance that reflects a significant uptrend. Indeed, we see support again and again when the price drops down near $33.50, since that price level provided strong support on at least three previous occasions.

Image

Image by Sabrina Jiang © Investopedia 2021

Emotional Price Levels

Other support and resistance levels that are influenced by human emotion include round numbers (since they are easy to remember), 52-week highs and lows, and historic events such as 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. Market participants often gauge future expectations based on what has happened in the past; if a support level worked in the past, the trader may assume that it will provide solid support again.

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.

Frequently Asked Questions

What are support and resistance levels and how are they formed?

A support level can be thought of as the floor and a resistance level a ceiling for prices in a market. Prices fall and test the support level, which will either "hold," and the price will bounce back up, or the support level will be violated, and the price will drop through the support and likely continue lower to the next support level. These levels are formed, in part, due to market psychology that establishes bullish sentiment at the support and bearish at the resistance.

Why are these levels important for technical traders?

Traders use support and resistance levels to plan entry and exit points for trades. If the price action on a chart breaches the support levels, it is seen as an opportunity to buy in or take a short position, depending on what the trader sees from other indicators. If the breach occurs on an uptrend, it may even be a sign of a reversal.

How does anchoring play into support & resistance levels?

Anchoring takes an arbitrary value and assigns meaning to it for traders. A previously established level of support or resistance may therefore become an anchor at which points future resistance or support will be observed - even though these points may not reflect any fundamentals. Likewise, round numbers such as $1,000 or $25,000 may serve as support or resistance levels, not because they are fundamentally-driven, but are symbolically meaningful as psychological anchors. As these levels are breached, traders may adjust their anchors accordingly.

The Bottom Line

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. Knowing what the market is thinking is the best way to determine what it will do next.