Those of us in the trading technology field are no strangers to support and resistance levels. It can be said that the accuracy of determining support and resistance levels largely determines the outcome of our trades.

Many people often ask, how can we know when the market trend will reverse? How can we precisely find entry or exit points?

Support and resistance levels are the simplest and most effective technical analysis tools for determining market reversals or pullbacks.

Today, I am writing this article to analyze the fundamental reasons for the formation of support and resistance levels from two aspects: the general trading behavior and the psychology of trading.

Only when you understand the root causes of the formation of support and resistance levels can you more accurately locate these positions and more precisely capture profits.

Without further ado, let's begin today's content. The article is relatively long, so I suggest you bookmark it for reading. If you find it helpful, please give me a like at the bottom of the article. Thank you.

The reason for the effectiveness of support and resistance levels, part one: everyone's logic for buying is essentially the same.

Advertisement

We must understand that the essence behind the financial market is actually a game between people, so we talk about human nature and trading psychology.

As a human, there are definitely weaknesses in human nature, especially some habitual thinking. What we can do is to use these habitual weaknesses in human nature to find the breakthrough points of everyone's emotions, and we can more accurately find some technical positions.

After we traders open a position, we may experience a lot of emotions internally:Concern: Is the price I bought at too high?

Fear: Will I lose money after I buy? If I do lose, how can I minimize the loss? What should I do if there's a pullback after making a profit?

Greed: How can I make more money? And make it quickly?

These emotions are instinctive human reactions, and each of these emotions can serve as a basis for us to judge support and resistance levels.

For example, the common anchoring effect: when we make judgments about something, we are easily influenced by first impressions or initial information.

Take our previous experience with buying pork as an example. It used to cost 10 yuan per jin (500g), but later it rose to 40 yuan. We thought it was expensive and didn't buy, hoping to wait until it dropped back to the original 10 yuan. However, the price of pork fluctuated for a long time, only dropping as low as 20 yuan. After a while, we also accepted this price of 20 yuan, and our anchor point changed accordingly.

In our trading, traders often use past lows or highs as anchor points to determine their current trading behavior.

Let's take a piece of market action as an example to analyze the psychology of traders and find an anchored support level.

After a significant drop from 4140 to 3880, the market began to stabilize and move upward, forming a bottoming consolidation pattern.

Let's analyze everyone's trading psychology: during a sharp decline, many traders, fearing losses, start to sell in large quantities, leading to a deeper drop. In this process, some traders will start to bottom-fish, or some short sellers will start to cover their positions, so there will always be slight pullbacks accompanying the decline.As the market continues to decline, the amount of capital entering to bottom-fish and go long increases, which creates a certain rebound trend.

At this time, several psychological states may emerge:

1. Feeling the urge to enter the market, but thinking the price is not low enough, and thus being reluctant.

2. Having entered from the lowest point, fearing the market will rebound, and taking a small profit and running.

3. Having bought at a mid-high, not-low position, and finally averaging down the cost, eager to exit without a loss.

The sentiment of wanting to make money but being afraid to make money is flying around the market, and at this time, the market will form a bottoming consolidation pattern, with most people waiting for the market to reach a low point, just like buying pork, holding money and waiting.

So at this time, the anchoring effect comes into play, and the low position everyone is waiting for is the lowest point the market has reached, which is 3880 points in this market segment.

When the market falls back to 3880 from 3940, a large amount of capital enters, the market reverses, and rises sharply.

This is the effective support level we are looking for.

By leveraging the public's logic for opening positions, we can find an anchor point, which can lead us to a relative support level. This support level may not be absolutely precise, but it is definitely a good entry point.Because it not only has psychological advantages but also technical trading advantages.

The closer we get to buying at 3880, the more cost-effective the trade becomes, because the closer we buy to 3880, the smaller the stop-loss space, and once the market reverses, the higher the profit-to-loss ratio and the more efficient the trade.

Let's do some calculations.

When the market falls from 3940, we start preparing to enter long positions.

If we buy at 3900 with a stop loss at 3880, the stop loss is 20 points.

If we buy at 3890 with a stop loss at 3880, the stop loss is 10 points.

The stop-loss space only differs by 10 points, but the final profit-to-loss ratio differs significantly.

For example, let's calculate based on the market moving up to 4040.

Entering at 3900 with a stop loss of 20 points and taking profit at 4040 for a profit of 50 points, the profit-to-loss ratio is 2.5:1.

Entering at 3890 with a stop loss of 10 points and taking profit at 4040 for a profit of 60 points, the profit-to-loss ratio is 6:1.Stop loss is narrowed by 10 points, and the profit and loss ratio differs by more than twice.

Reason two for the effectiveness of support and resistance levels: similar selling logic among traders.

In a continuous uptrend, many traders will gradually sell their orders, and everyone will have similar selling logic.

The first type is that after accumulating some profits, some people will choose to take the profits and close their positions, at which point the market will start to correct as these people close their positions.

The second type is that some people are indecisive; as soon as they see profits being given back, they want to close their positions, but they are not willing to do so at this price. Instead, they wait for the market to rise to the previous high before closing, so the market tends to rise in a pattern of reaching the previous high, giving back, and then reaching the previous high again.

The 15-minute K-line chart of the glass contract 2305. The market started a bullish move from 1351, after a series of wave-like rises, it finally surged to 1485 with a volume increase, then a wave of selling and closing orders came, and the market began the first deep downward correction.

After the correction trend was formed, many people who originally had strong bullish expectations started to panic and wanted to close their positions, but they were not willing to give back their profits, so everyone was waiting for the market to return to the previous high before closing.

At this time, some bearish traders and those who are adding to their positions will enter the market, causing the market to rise again.

Near the same high point of 1458, a large number of traders began to sell, and the market fell sharply. Let's take a look at the following schematic diagram.This glass contract underwent a period of consolidation and correction after a second surge in the market, followed by a significant decline, at which point the pressure level took effect.

Precautions for Support and Resistance Levels:

1. Do not demand absolute precision.

After a trend in the market, due to the shift in trading sentiment and the tug-of-war between bulls and bears, a period of consolidation will inevitably form. This is the time to look for support and resistance levels.

However, these levels are not a matter of pinpoint accuracy; they are a range. As long as entries and exits are made within this range, they can be considered effective.

I understand that everyone wants to find the most perfect entry and exit points, but trading requires a certain margin of error. By managing position size, success rate, and risk-reward ratio well, it is still possible to make money.

2. It is best to wait when using support and resistance levels for trading.

For example, after the market tests the support or resistance level, and we need to open or close a position, we can wait to see how the market behaves at the support level, to observe whether the market stabilizes or breaks through.

Try not to enter trades directly when the price tests this level of resistance.For instance, after a price test reaches the support and resistance levels, it is advisable to wait for the formation of a reversal candlestick pattern before taking action. This approach enhances the stability of trading.

Trading is essentially a psychological game. If you can thoroughly understand human nature and control your own greed and fear, you are likely to make money in the market.