InvestorQ : Is there some logic behind how these supports and resistances get created in the markets?
Maniish Lofar made post

Is there some logic behind how these supports and resistances get created in the markets?

2 years ago

The supports and resistance levels are basically an outcome of how human psychology behaves. When a similar patterns comes you see that people to react in a similar. That is because greed, panic, frustration are all universal sentiments and they tend to elicit similar reactions over period of time. Let’s use a few examples of market participants to explain the psychology behind support and resistance.

Let us assume there are buyers who’ve been buying a stock close to a support area. Let’s say that support level is Rs.50. They buy some stock at Rs.50 and now it moves up towards the level of Rs.55. The buyers are happy and want to buy more stock at Rs.50, but not Rs.55. They decide if the price moves back down to Rs.50 they will buy more. They’re happy but want more and are creating demand at the Rs.50 level.

At the same time, let us assume that there is another set of people in the markets who thinking slightly differently. These are the people that were uncommitted to any particular level in the stock. They were thinking about buying the stock at Rs.50 but never really got themselves down to buying the stock at that price. Now the stock is at Rs.55 they look back and regret not buying it at the lower levels. They decide that if it gets to Rs.50 again they will not make the same mistake and they will buy the stock this time. The combination of the first two set of players creates a demand zone around Rs.50. You will typically find that such demand zones tend to be psychologically clustered around whole numbers. This is more psychological as we would prefer to buy a stock at Rs.100 rather than Rs.101. Alternatively we may prefer to sell a stock at Rs.100 instead of at Rs.99.

Finally, let us assume that there is a third group of investors who have actually bought the stock below Rs.50; at a price range of Rs.42-44. When the stock got to Rs.50 they sold their stock only to watch it go to Rs.55. Now they want to re-establish their long positions and want to buy it back at the same price they sold it, Rs.50. This will at least ensure that they are neutral in their position, excluding their transaction costs. They’ve changed their sentiment from sellers to buyers. They regret their sale and want to right that wrong. This creates more demand. Finally, let us put all the above situations together to understand how this psychology creates supports. It is the joint psychology interface of the above three sets of groups that actually creates a support for the stock at around Rs.50.

But, what about resistance levels and how are they created? Let us just change tack to help to understand resistance levels from a market psychology point of view. Let us get back to the three participants above. Take all the above participants and say they all own the stock at Rs.50. Imagine yourself as one of the owners at Rs.50. The stock goes to Rs.55 and you don’t sell. Now the stock goes back to Rs.50, where you own it. What are you feeling? Regret for not selling it at Rs.55? Now it goes back to Rs.55 and you sell as much as you can this time. So do the other owners of the stock. The stock can’t get past Rs.55 and retreats. There at least three groups of stock owners that are trying to sell their supply at Rs.55. This creates a resistance level at Rs.55. In a nutshell, both supports are created by a combination of greed, hope and confidence. On the other hand, resistances are created by a combination of fear, despondence and pessimism.