Finding Psychological Support and Resistance Levels
It is a common thought that there is only one kind of support and resistance, and it occurs from only one thing: the price. While support and resistance lines are important due to price, some prices are more important than others. These support and resistance lines are what are known as psychological support and resistance levels.
Psychological support and resistance lines occur not because of the perceived importance of a particular price to a stock, bond or security, but due to the fact that it is a “psychologically” important number. Believe it or not, people are naturally attracted to numbers that are prime, as well as numbers that the human brain considers to be “even.”
These numbers are usually what we consider to be rounded off. For example, the Dow Jones Industrial Average has a very psychological support and resistance line in the value of 10,000 because it's even and round. On a smaller timeframe, a single stock might find psychological support and resistance at even dollar amounts like $25.00 and $26.00, or every $5 dollars from $20 to $25 and then $30 per share.
What Makes These Numbers Important?
If someone were to ask you to name five numbers off the top of your head, it is highly unlikely you would name the five numbers listed above: 10,000, 26, 25, 20, and 30. Instead, you'd probably pick a whole batch of random numbers, not knowing the importance of your selection.
However, when traders step into their trading game, they encounter numbers that are more important than others. For example, if a trader goes to set a stop loss and take profit, all things being equal, he or she is much more likely to enter in $25 for a take profit and $15 for a stop loss than he or she is to enter $24.92 and $14.92. Human brains naturally desire to round up or round down, and as a consequence, our natural desires tend to be exemplified in markets where our subconscious picks evenly round numbers to mark as important points on a chart.
Besides simple numbers, the collective consciousness of all traders, speculators and investors tends to put value in events like all time highs or lows, or even all time highs and lows. Likewise, within one stock market, two companies may respond differently to a 10 week moving average or a 20 week moving average, depending on the history of the response of the stock to the indicator.
Applying the Psychology
Next time you open a chart, scroll through to observe psychologically important support and resistance lines. If there isn't an already established trend at a particular value, it is likely that the support or resistance level is weaker, since the only market action at the particular level is due to rounding. If there is already support or resistance at that level, the addition of rounded stop loss and take profit orders will only stand to increase the potency of the support and resistance. For some stocks or securities, this effect may be best viewed on a short term horizon, where even a small amount of orders can greatly influence immediate price changes.
Finding and understanding the importance of psychological support and resistance won't only make you a better trader, but also a more profitable trader. As with most charts, there is usually more than meets the eye.