Psychology of Support and Resistance

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Introduction

From the coaching sessions, the key learning points in understanding Trendlines are :

There is a pattern of Support and Resistance

Over time, Resistance becomes Support, or Support becomes Resistance

This article explains the reasons why that happens from the psychology of the traders, or investors, or generally called market players.

Market Players

Assuming there are three types of market players – The Longs , The Shorts and The Un-committed.

The Longs – market players who had committed to trades and have been holding on to the invested portfolio. They bought the shares.

The Shorts – market players who had committed to sell at certain price or selling or sold already.

The Uncommitted presently – Those already bought / sold off their stocks, and those still undecided and are waiting for “better signals” from the market.

Case Study – 1 “How the Support Line is formed”

Take the case when the market traded at a price of $5. The Longs have bought at $5, or The Longs have been holding on, not selling as they hope to sell only at higher price than $ 5. The Shorts are out from the market due to earlier committed sale price of $5. They had sold already. The Uncommitted are still waiting, or hesitating.

Over time, let’s say the market rises above $5. There seems to be good news that market will go higher.

The Longs are cheerful, waiting for higher price to make profit. With greed or strategies, they are ready to buy more if the market drops or dips to “safe” buying price, which is $5, as proven right now.

The Shorts are angry and frustrated that they should not have sold at $5. Wanting to get back at the market if it drops to lower price, i.e. $5, which was the price they sold.

The Uncommitted realize that they should not wait, as market is moving up. They resolve they will enter the market when it dips, say at $5.

When the market does dip to $5,all the above three groups of market players jump in to buy at that price, i.e. the price is supported at $5 for that period of time, This behavior continues until these players get exhausted with fund, or did not attract more players to come in to buy at $5.

A Support Line is formed.

Case 2 – “How the Resistance Line is Formed”

The same psychology applies for the Resistance Line.

Over time, let’s say the market dips below $5. There seems to be bad news that market will go further down.

The Longs are angry and frustrated that they should not have bought or held on. Not selling at $5, before the price dropped, and the $5 mark becomes a psychological level whereby when the market move back to $5, the Longs would like to sell quickly at $5, not wanting to be frustrated again, after all there are many bad news in the market.

The Shorts are cheerful, as they have sold before the price dropped below $5. For those Shorts who sold and made profit, they would like to buy back at lower price, and get ready to sell at the magic $5 price level again.

The Uncommitted, those did not take part in the market yet, and those who hesitate to buy further or to sell their existing stock, realize that they should be more decisive before as market dropped. Such regret make them to do something when the price move up to $5 again.

When the market does rise to $5,all the above three groups of market players jump in to sell at that price, i.e. the price ceiling is then at $5 for that period of time, This behavior continues until these players get exhausted with stock in hand, or did not attract more players to come in to sell at $5.

A Resistance Line is formed.

Case 3 – Previous Support becomes today Resistance

Say, previously the price was supported at $5 like case 1. At that point, if the support is significant, i.e. extended over a sizable period of time with a large number of players – longs, shorts and uncommitted.

Over time, the equilibrium was disturbed, e.g. there was no more buying pressure as the buyers then exhausted their fund. Then the market gives way, dropped in price. The psychology like what was described in case 2 becomes true again. The Longs are angry, Shorts are happy, uncommitted still hesitate. If it was a significant Support line, i.e. involving a lot of players, the emotion and sentiment among these players have great impact and last long time.

Say after a period of time, days, weeks, years, the market dropped and get supported at another lower level by another group of players, who supported at that new lower level and helped to move the market up to $5 price level. At this point the original group of people are triggered which touched their old emotion and feeling, with large number of them wanting to sell at $5.

Hence the Resistance line (same level as previous support line of $5), is formed due to selling pressure.

Case 4 – Previous Resistance becomes today Resistance

The same logic and argument applies.

What Type of Market Players are you?

The above describes the three types of market players. These types of human behavior : regret, rejoice, frustrated, taking revenge, panic, waiting, reacting make up the market.

If you also behave the same way, you also contribute to the support and resistance line formation.

Do you want to behave that way?

As a disciplined investors, we would like to be cool and objective and make careful observation of these behaviors through technical analysis and make good strategies on our investment decision.

What then should be a possible trading strategy when you see a clear formation of range of prices with clear resistance and support? (please post your views to the class)

End.