Forex Psychological Levels: Why Do They Work and How to Trade Them! 

 September 2, 2017

By  Advanced Strategies

When trading the markets, you might have heard about the term “psychological level.” If you were wondering what this meant then fret not. Psychological level is a term that is used in the markets when price is approaching a key level. The psychological level is nothing a common round number. For example, if you consider the EURUSD chart, levels of 1.10, 1.20, 1.30, etc. are considered key psychological levels.

The reason why psychological levels are important is because they play a key role as support and resistance levels in the market. Many institutional entities and financial hedge funds tend to trade based off these levels.

Why Do Forex Psychological Levels Work?

Obviously, setting your trade entry or exit at levels such as 1.10 or 1.20 sounds more reasonable and simple compared to placing a buy or a sell order at 1.10192 or 1.2019. Another reason why the psychological levels are used is because they are also easy to identify. You can see psychological levels at work in almost every market that you analyze.

Let’s look at a very recent example. In late August, early September of 2017, EURUSD rallied towards a psychological level of 1.20. As expected, price promptly reversed at this level. The chart below shows this example…

Forex Psychological Level of 1.20 and EURUSD reaction to this

In the above chart you can see that first, EURUSD broke the psychological level of 1.20. Following this break, price continued to decline further. Finally, after years, quite recently, EURUSD approached this level again. You can see how quickly EURUSD posted a reversal. What this means is that when a psychological level is broke, you can expect price action to continue in the direction of the trend. Likewise, when a psychological level is tested and price reverses you can expect the reversal in prices.

Besides the EURUSD example, and widely cited phenomenon is Gold and also oil charts. In Gold, the psychological levels are the $1000, $1100, $1200, etc. levels. When gold prices reach these levels you can expect the markets to become very active. Traders will be looking at how price reacts to these levels. If price breaks the level, then you can expect a flurry of buying activity if the breakout is to the upside for example. The next chart is that of gold with $1200 and $1300 psychological levels shown on the chart.

Psychological Levels Respected Even in Gold or XAUUSD

In the above chart you can see how the psychological level of $1200 was tested twice. Because price first broke the $1200 level and then fell back, you can see increased buying activity in the gold market. Finally, the recent breakout of $1300 psychological level is another indicator to the upside.

No sooner will gold prices drop back to $1300, you can expect support to be formed here as buying activity increases strongly at this psychological level. Depending on the markets that you trade, you can also make use of volume to understand if a break of a psychological level will hold or not. By combining not just price but also volume, traders can get additional validity.

Remember that just because price is approaching a psychological level it will not behave the way you want to. Therefore, traders who set their orders at psychological levels without analyzing the markets can be risk of a losing trade. Based on the time frame that you are trading, psychological levels can change. For example on an intraday chart, you can think of 1.125 or 110.50 or 109.25, etc. as psychological levels.

How Can You Use these Forex Psychological Levels to Trade?

A psychological level can be used as a regular support and resistance level. When price is approaching a round number, you need to pay extra attention to this. Because just about every trader is watching the number it gains more importance. Psychological levels can be used on intraday charts too. The chart below shows the EURUSD 4-hour chart. Here, we use the psychological levels of 5. Thus you can see price levels such as 1.115, 1.1250, etc.

Psychological levels in action on intraday charts

If you observe the chart closely you will see how price reacts to these levels. Now with the psychological levels, traders can then analyze the chart and plot potential levels of support and resistance. Notice the support and resistance level identified around 1.0850. You can see how this level first served as support and after breaking this level, price then tests this very level where resistance is formed (seen in the next chart below).

Important support and resistance levels are formed when there is confluence with psychological levels

Traders can also make use of candlestick patterns or other technical indicators to understand what price will be doing when it reaches a key psychological level. While it might sound tempting to rush into a trade at psychological level, it is always important to not what price action will be doing at this level.

In conclusion, psychological levels are merely key round numbers in a price chart. They gain importance as almost all traders keep an eye out for these levels. Depending on how price reacts and based on your analysis, you can build a profitable way to trade based off these psychological levels.

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