Support and resistance levels are simply historic price points where the price tends not to exceed this level. Support and resistance was best described by Curtis M. Faith in the “Way of the Turtle” as a result three market factors:
1.Recency Bias
The tendency to place the most confidence on a recent price high or low. For instance, anew price will be higher in people’s opinions than a price point 2 years ago.
2.Anchoring
a. Because of the recency bias, all price action will now be “anchored” to this new high or low point.
b.This is because recent prices are easy to see on charts, which therefore makes it readily available data and psychologically significant.
3. Disposition effect
a. The tendency for traders to quickly take a small profit as opposed to letting the profits get larger over time.
b. The fear, in most traders, of losing profits increases with time.
But how do these effects create support and resistance levels?
As mentioned for anchoring & recency bias, the price levels will be created by a price point failing to be exceeded thuscreating an anchor (anchoring). Where the most recent anchor will have the greatest influence.
Disposition causes support and resistance levels because, for example, traders will tend to buy at a low anchor point and exit (sell) that position at the next highest anchor instead of waiting for further profits.
The perception of most traders that support and resistance is a real phenomenon adds to the reality of its existence because the market behaviour of those who believe in it reinforces the phenomenon. For instance, if many traders believe there will be significant buying when the price drops to a certain level, they will be more likely to buy when the price reaches this level, believing the price will rise. This becomes a self-fulling prophecy.