The Principle and Application Analysis of Support and Resistance Levels

First, the formation principle and function of the support line In the price chart, when a certain price range has been the low point of a correction many times, the straight line formed by connecting these similar lows is the support line. It intuitively reflects the market state where buyer power begins to increase near a specific price and demand gradually exceeds supply. When the price falls back to this area, buying interest increases and sellers' reluctance to sell appears, which often prompts prices to stop falling and recover. The market logic behind this is:

Due to the repeated fluctuations in the previous price range, a large number of transactions have accumulated, forming a so-called "transaction-intensive area". When the market price falls back from above to near the support line, traders who were previously short may have taken profits and reduced the selling pressure; while investors who are optimistic about the market outlook tend to buy on dips to form new demand; at the same time, some holders who bought at high levels are unwilling to sell easily because they are deeply entangled, further locking in the chips. These factors together cause the supply in this price range to be temporarily less than the demand, thus building a strong support foundation. In addition, the historical market has been supported and rebounded here many times, which has also strengthened the psychological expectations of market participants for the region. In the absence of major bearish news, prices are often prone to gain support here.

In technical analysis, a high turnover area means a high turnover rate. Investors who buy in this area have their costs concentrated here, and if they want to make a profit, they need the price to rise above the cost area. Therefore, as long as they are still confident in the market outlook, they will not easily sell near the cost price. This reluctance to sell makes it difficult for prices to effectively break through the area. Even if the support line is briefly broken, without a significant increase in volume or substantial bearishness, the price may still quickly return to the support line, thus strengthening the psychological support of the market again.

After the price gains support in the transaction-intensive area, there are usually two possibilities for subsequent development: one is to rebound and recover; the other is that the confidence of the holders collapses and they sell a lot, resulting in the support line being effectively broken down and the price continuing to decline.

The support line is not only generated in the transaction-intensive area. When the price pulls back to 50% of the previous wave of increase, it often encounters support, which reflects the general psychological expectation of the market, which is often referred to as the "symmetry principle" in technical analysis. In addition, the obvious low point of the stage often becomes the psychological support level that investors pay attention to.

Second, how to identify resistance and support levels Resistance and support are two typical manifestations in the market price movement space. Chart trends are essentially traces of the power game between the long and the short sides. The multi-party dominance drives the price up, and the short side dominates the price down. This is similar to climbing and skiing. When you go up a mountain, you will encounter obstacles to slow down the speed, and when you go down, you will also encounter support and it is difficult to continue. It is reflected in the market as resistance and support.

1. Resistance level - usually a price area where bears are strong and bulls are relatively weak. In actual trading, the following positions tend to form obvious resistance areas due to the convergence of market expectations:

(1) When the price opens lower than the previous day's closing price. During the subsequent rebound, resistance often forms near the previous closing price. This is because after the market has rectified, there is a consensus between the long and short sides on the previous day's closing price. If the day opens lower, it indicates that the selling pressure is heavy at the opening. When the price rebounds, it will not only encounter new selling, but also when it is close to the previous closing price, the sell orders accumulated in early trading will also play a role, making it difficult to rise overnight.

(2) Prices fall after the opening of the day. If there is significant selling near the opening price, then the price will encounter resistance when it rebounds to the opening price.

(3) Early price highs. The reason why this position forms a high is usually due to the accumulation of obvious selling pressure. When the price rises again close to the previous high, new short-selling forces may intervene, and bulls will tend to be cautious. It is easy to form a pattern similar to the "M head" on the chart, and the high of the right shoulder is often lower than that of the left shoulder.

(4) Some key integer thresholds, due to psychological effects, also often become important resistance in the process of price increases.

The purpose of identifying a resistance zone is to find a relatively ideal selling position, usually before the price enters the anticipated resistance zone, or when the price falls back from the high and approaches the high for a second time.

2. Support levels - areas where prices are difficult to continue falling. Common support levels are as follows:

(1) If the price rises after the opening and then falls back to the opening price, there is usually some support due to the accumulation of initial buying there.

(2) The previous day's closing price. If the price falls from a high level, there is often a supporting role near the previous closing price.

(3) Early price lows. The last significant low area formed can easily become a psychological support level for the market, and its principle is similar to that of a resistance zone.

(4) Once an important resistance level in the early stage is effectively broken through, the original resistance may be converted into support when the price steps back to that level again.

Identifying support levels helps investors identify potential low buying opportunities.

From the above analysis, it can be seen that support and resistance can be transformed into each other. After the original resistance level is broken, it may be transformed into a new support level, and after the original support level is broken, it may also be transformed into a new resistance level.

Accurately grasping the support and resistance levels can help to judge the overall strength of the market. For example, when the price successfully breaks through an important resistance area, it usually indicates a strong market trend and can be considered to follow the trend. When the price falls below a key support area, it may mean that the market is weakening and needs to be cautious.

III. Use support and resistance levels in trading To find relatively reliable support and resistance levels, it is recommended to start with medium and long-term charts (such as daily, weekly, and monthly charts) for analysis.

(1) Look for the transaction-intensive area or consolidation range. This range is the area where the long and short sides trade the most actively and diverge the most. Market liquidity is related to the difficulty of value judgment here. Once the price breaks through or falls below this dense area, it often triggers the joint action of stop-loss orders and trend-following orders, which drives the price to accelerate. Then when the price pulls back and sorts out, the broken boundary will become an important support or resistance level. Its importance is proportional to the running time and space after the breakout.

(2) Pay attention to the significant high (head) or low (bottom) in the previous period. The early head is often the resistance level of the current rebound, while the early bottom is often the support level of the current pullback. Its effectiveness is related to the magnitude and duration of the rebound or pullback.

(3) Observe the symmetric relationship. Markets sometimes exhibit symmetry in time or space. For example, the previous upward process was smooth and unimpeded, and the corresponding downward process may also lack support. There is also the possibility of symmetry in the time period of price operation.

(4) Utilize the Golden Ratio. Fibonacci numbers are the basis of many technical analysis tools, and the golden ratio derived from them (e.g. 0.382, 0.5, 0.618) is widely used in nature and in the market. Take the highs and lows of a trend for the golden ratio, and the support/resistance levels for a pullback or rebound often appear near these ratios.

Some relevant trading ideas for reference:

(1) Consider selling near the upper edge of the transaction-intensive area, consider buying near the lower edge, and set a stop-loss and reverse follow-up strategy after the breakout.

(2) Consider selling near the previous high and buying near the previous low, and also need to cooperate with the breakout stop mechanism.

(3) Calculate the golden section of an uptrend or downtrend and consider buying when the price pulls back to 0.5 or 0.618, or selling when the price rebounds to the corresponding ratio.

(4) Pay attention to the psychological reaction of the market near the integer price.

What needs to be made clear is that accurately identifying and applying support and resistance levels requires long-term market observation and experience accumulation, and gradually cultivating a sense of disk.

IV. Mutual transformation of support and resistance lines The formation and transformation of support and resistance lines are largely based on the group psychology of market participants. Psychological factors are one of the main theoretical grounds for their effectiveness.

Market participants can be roughly divided into three categories: bulls, bears and bystanders. Bystanders can be subdivided into currency-holders and holdings. Suppose prices start to rise after stabilising in a support area, bulls who buy in this area will think they were right and may regret not buying more; bears who sell in this area will realize that they may have made a wrong sale and hope that the price will fall back to the area again to cover. The psychology of currency holders and shareholders is similar to that of bears and bulls, respectively. All four groups are likely to develop a willingness to buy at the next opportune moment.

It is this underlying willingness to buy that once prices start to recover from the support area, a slight pullback will attract buyers to intervene, and often before the price has fallen back to the original support level, the buying force has already pushed the price higher again. The more frequent the transactions in the area, the more investors' interests are tied to it, and the more important the support area is.

On the contrary, if the price fails to rise and falls below the support after it has been supported, then the bulls buying in the area will realize that the judgment is wrong, while the bears and wait-and-see will rejoice or strengthen the bearish view. Once the price subsequently rebounds and has not reached the original support, it may encounter selling pressure from the unhedging or stop-loss order, causing the price to fall again.

The above psychoanalytic process applies equally to the resistance line, but in the opposite direction.

An important conclusion to draw from this is the role of support and resistance. Once an important support level is effectively broken, it may later turn into a resistance level; likewise, an important resistance level may also be transformed into a support level after being effectively broken through. This shows that their roles are not fixed, and the key to transformation is whether it is broken by a strong price movement.

How to define an "effective breakout"? It is difficult to use an absolutely accurate number to divide it. Usually, the more the price crosses the support or resistance line, the more effective the breakout is. In practice, some empirical ranges are often referred to, such as 3%, 5%, 10% and integer price levels. A range of about 3% is more suitable for short-term key levels, 10% is more biased towards long-term trends, and 5% is in between. Integer levels are more reflective of market psychology. For example, 4.99 yuan and 5.00 yuan are almost the same in value, but on a psychological level, the former gives the feeling that it has "fallen below 5 yuan", while the latter is still in the "5 yuan mark".