Trading Psychological Whole Numbers
03/02/2013 9:00 am EST
There are many different ways of looking at support and resistance, with few as compelling as the study of "psychological whole numbers," says James Stanley of DailyFX.com.
If you've been trading on charts for long enough, you've surely noticed the odd behavior that prices will have a tendency to exhibit when a "round" number (prices such as .9900 or .9800 on AUD/USD) is seen. Below is a picture of the aussie-dollar's struggle to get over the 'parity' level earlier this year.
As you may know, parity is the price of 1.0000 on AUD/USD; or to put it another way-this is when one Australian dollar is worth one US dollar.
Things get weird at this exchange rate.
As human beings, we have a tendency to value simplicity, and our own internal psychology plays a large role with the odd price behaviors that may be exhibited at these "psychological levels."
Let's walk through a simple example:
If someone were to ask you how much you spent on your computer, you'd likely respond with an amount rounded to the nearest hundred ('ah, about $800,' or 'I paid $900.') Sure, you can give an exact answer like $659.96; but that doesn't really make any sense. If I had asked the question, I probably don't care about the $39.96; I just wanted a ballpark idea for how much you paid for the computer.
Out of simplicity, most people (most of the time) will automatically round to the nearest whole number.
This happens in trading too.
What Are the Whole Numbers?
Traders will often call these whole number intervals "double-zeros," as these prices are at even numbers such as 1.31000 on EUR/USD, 1.57000 on GBP/USD or 132.00 on GBP/JPY. The chart below will identify the 'double-zero's' on the sample EUR/USD chart.
Some traders will even take this a step further by looking at the number directly in the middle of these whole numbers or "the fifties." These levels, such as 1.31500 on EUR/USD or 131.50 on GBP-JPY can often come into play in the same manner as the "double-zeros."
One look at any chart, and you will notice that there will often be some element of congestion at these levels as prices move up or down. The chart below illustrates EUR/USD with "double-zeros" and "fifties" denoted:
Notice that many of the price swings on the above chart takes place around one of these levels. This is why we want to incorporate these levels into our support and resistance studies.
NEXT PAGE: Why Do Psychological Levels Work? |pagebreak|
Now let's look at the same chart, with some of these swings identified:
This is why these prices can work so well as support and resistance. Because people (traders) watch, and care about these prices. Not every one of these prices are going to function as support or resistance, but enough do that these levels warrant the trader's attention.
Why Do Psychological Levels Work?
Psychological support and resistance often works because of the very fact that we looked at to start this article. As human beings, we value simplicity; we think in whole numbers-and often, when placing stops or limits, we use these prices.
These stops and limits can massively alter order flow and price changes. Let's use the EUR/USD as an example, when price made a large move down around the news and events of the European Debt Crisis. On the chart below, I've marked 3 strong inflections off of the 1.3000 neighborhood:
Each time price approached 1.3000, the currency pair bounced back up. This can be explained for a few reasons.
Perhaps traders saw the price of 1.3000 and thought "whoa, that is way too cheap. I'm going to buy some euros."
Or, more likely, as traders were opening short positions, they set profit targets at an even 1.3000, so that when that price was hit-they had a pending order to "buy to cover." This profit target order to close their position created demand in the market (they were buying to cover, and this buying interest is considered "demand").
After the first inflection, traders may not have been extremely bullish on the prospect of pushing price much lower than 1.3000. After all, this price has already been exhibited as support.
In many ways, untested "psychological" levels can be looked at like pivot points. An area where there may be some element of support or resistance, but unfortunately it is impossible to tell until after the fact.
In general, round numbers such as 1.30000 on EUR/USD or 1.0000 on AUD/USD or USD/CAD will garner more attention than a more pedestrian level like 1.31000 on EUR/USD; so many traders will often assign a higher degree of strength to the more rounded intervals.
Where traders can really find value with these levels is when prices may have resisted or been supported there in the past. This tells the trader that others are noticing and acting on those prices, and the potential for the "self-fulfilling prophecy" of technical analysis may potentially be considered with more strength.
James Stanley, Trading Instructor, DailyFX.com