Technical analysts use support and resistance to identify 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. The article Interpreting Support and Resistance Zones examines the basics of this technical analysis tool. This article will examine how support and resistance zones are largely shaped by human emotion and psychology. (Every time an investor talks about getting in low or picking entry and exit points, they are paying homage to these men. See The Pioneers Of Technical Analysis.)
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The Psychology of Support and Resistance
In a financial market, there are three types of participants, at any given price level:
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 buy to cover (exit the position) to get out at, or near, breakeven, if 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 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, 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, if price comes back to the previous support level, 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.
These examples illustrate an important technical analysis principle: what previously acted as support will eventually become resistance. Conversely, levels that formed resistance will act as support, once 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. Figure 1, for example, shows a 15-minute price chart of Coca-Cola (NYSE:KO). The yellow line represents a price level ($67.60) that has flip-flopped between acting as resistance and support, and back to resistance.
Support and resistance zones are not only seen at particular prices; they can exist along with up or down trendlines. Figure 2, which shows a two-year daily chart of Johnson & Johnson (NYSE:JNJ), illustrates how these zones can appear as horizontal lines (the support in this example) or with prices that occur along a trendline (the resistance level in the chart). Time and again, over the course of two years, these levels were tested, breaking significantly above or below the trendlines only twice. (We'll show you which candles shed light on successful trend trades. Check out Inside Day Bollinger Band® Turn Trade.)
Human Emotions and Behavior
Fear, greed and herd instinct are terms that often come up when discussing the financial markets. This is because human emotions and behavior are largely responsible for price movements in the markets. A price chart, then, can be thought of as a graphical representation of emotions such as fear, greed, optimism and pessimism, and human behavior, such as herd instinct. Price charts illustrate how market participants react to future expectations. (Find out how your mindset can play a larger role in your success than market influences. Check out Trading Psychology And Discipline.)
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. Figure 3, which shows a daily chart of Eli Lilly (NYSE:LLY), shows how two previous price peaks formed resistance that reflects a significant uptrend. Traders who had studied this chart, and drawn a trendline connecting the two price peaks that occurred in early August and mid-October of 2010, would have expected resistance once price finally reached the trendline's projected path. Indeed, this is what happened in April 2011, as price met the trendline's path. Similarly, traders might expect to see support again when price drops down near $33.50, since that price level provided strong support on at least three previous occasions.
Figure 4 further demonstrates this concept, as price is drawn like a magnet to the trendline on a daily Berkshire Hathaway chart (NYSE:BRK.B). In this case, a down trendline acts repeatedly as resistance over the course of six months. Once price is successful in breaking above the trendline, the line forms significant support over the next several months.
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.
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. To learn more, refer to Gauging Major Turns With Psychology.)