What are psychological levels in Forex and how to use them?

It’s very difficult to predict what a single trader will do next. However, predicting how the market will react in a given situation is possible. Markets are influenced by the psychology of masses. Psychological levels in trading exist because masses believe they are real and place orders accordingly. And therefore understanding psychological levels is highly important in technical analysis. Let’s find out what they are and how to use them in trading currency pairs.

Psychological level meaning

Psychological levels on Forex charts are created at around round numbers. When currency prices end in 000, 250, 500 and 750, we have round numbers. However, keep in mind that price endings with 000s and 500s are more significant than endings in 250s and 750s. For example, for EUR/USD round numbers are 1.0000, 1.0250, 1.0500, 1.0750 etc. Keep in mind that not all round numbers are psychological levels. Each currency pair has its own psychological levels. These levels serve as horizontal support and resistance levels and can be traded similarly.

Psychological levels in trading

No matter which asset you are trading, psychological levels exist across all asset classes. And in all markets they work as support and resistance levels. However, prices respect psychological levels in some markets more than others. For example, currency prices that are highly correlated with other pairs or commodities have less of a mind of their own and decisions are mostly made based on what the other currency’s performance will be like.

Why do psychological levels work?

Now that we have figured out what psychological levels are, we can answer the question of why they tend to work. It’s widely known that big institutions such as hedge funds, mutual funds, etc. buy and sell currencies from around round numbers. In addition, big institutions do not use market orders. Placing limit orders around psychological levels is precisely what makes them work.

At this point you might be wondering why big institutions wouldn’t use market orders since the Forex market is the most liquid in the world. The answer is simple, yes its liquid but the highest liquidity occurs around significant levels, during certain trading sessions.

One more reason why these levels work is that humans love simplicity. We usually think about round numbers when we’re considering placing limit orders. Limit orders are order types that help us buy or sell securities from predetermined points.

Reliability of psychological levels

When price gets closer to these levels, there are 3 scenarios out of which one will happen: price respects the level and traces back, price breaks the level or breaks and traces back momentarily, leaving shadow outside the level. When price action leaves a shadow outside a significant level and returns back, it’s called false breakout. Traders react to each scenario differently and we’ll discuss what to do in these cases later.

False breakouts occur often around psychological levels. These breakouts are dangerous for traders as they trigger Stop Loss orders which happen quite often.

Psychological levels are not super reliable on their own, however, they can be coupled with various indicators and trading strategies to produce more precise signals. And most traders do just that. Most traders do not trade psychological levels separately. They use them in combination with various tools.

Psychological zones are more accurate than psychological levels. Some traders take these levels as zones instead of single price points. And therefore, Stop loss orders are wider. Wider Stop Loss orders enable traders to avoid false breakouts.

Psychological Levels on Forex Charts

As we’ve already mentioned, psychological levels are actively used in Forex. In this Euro vs US Dollar example we can see how price respects significant psychological levels, namely: 0.99500, 1.00000, 1.00500 and 1.02000. These levels work as support and resistance levels. There’s two general ways that traders can use these levels: they can trade reversals from the significant levels or breakouts. And we’ll discuss in detail how to trade psychological levels below.

How to trade psychological levels in Forex?

You can either trade breakouts or reversals from the psychological levels. Generally when price gets closer to the level and volume increases, this might be an indication of upcoming breakout. Breakouts require energy and determination from traders and high volume can bring that energy. On the other hand, if volume decreases near the psychological level, this might be a sign of running out of energy and upcoming price retracement. There are various volume indicators that can help traders in this regard.

The biggest danger traders face when they’re trading breakouts are false breakouts. False breakouts can kick traders out of great trading positions and force them to revenge trade and take significant risks chasing the price. To avoid false breakouts, traders use a bit wider Stop Loss orders.

Psychological levels can give us clues where to place Stop Loss and Take Profit orders

Often traders have clear Stop Loss targets but profit points are not always visible. In this regard, psychological levels can be beneficial for traders as these levels often become support and resistance levels.

Psychological levels can help us trade all time high and all time low prices

All time high and low prices are less frequent in Forex markets than they are in Stocks. And rightfully so. The FX market is more cyclical in nature than stocks. However, on rare occasions, prices do hit ATHs and ATLs. When that happens, traders do not have prior price peaks to serve as support or resistance. And the psychological levels can easily take that function on their shoulders.

Psychological levels are different for every currency pair

Each currency pair has a different valuation. And no wonder each one has different psychological levels. Often central banks use these significant levels to know when to intervene.

The main takeaways

To sum everything up, psychological levels are price round price points on the charts that tend to be respected by traders. One particular trader might not be interested in trading psychological levels but the fact that masses use them as support and resistance points, makes psychological levels real. Currency prices that end in 000, 250, 500 and 750 are round numbers and psychological levels. The levels can be traded as they retrace or as the breakout from support or resistance.

Many traders use psychological levels in combination with various indicators and trading strategies. While others solely base their decisions on them. It’s recommended to use the levels in context and in combination with other tools to increase the likelihood of success.

FAQs on psychological levels in forex

How do you use the psychological levels in forex?

Psychological levels are used as horizontal support and resistance levels. Traders can trade these levels for trading breaks or price retracements. Increase in trading volume when price nears the psychological level can signal potential breakout. On the other hand, decrease in volume might be a sign that the breakout will not happen.

How to identify the psychological levels?

Psychological levels are easy to identify since they form around round numbers. If you see that a price tests and respects a round number, you have a psychological level. The more touching points the price has, the stronger the level is.

Why do psychological levels work in trading?

Psychological levels are created around round numbers. And they tend to work as that’s where traders are placing their limit orders. Limit orders are creating support and resistance areas around round numbers. In short, psychological levels work because traders believe they work and make decisions based on their beliefs.