THE PSYCHOLOGY OF SUPPORT & RESISTANCE
In a financial
market, there are three types of participants, at any given price level:
Traders who are
long and waiting for price to rise.
Traders who are
short and hoping that price will fall
Traders who have
not decided which way to trade
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.
