So I’ve been learning about the basics of support and resistance … and a big theme is resistance is hard to break, but once it break through it’ll move dramatically and usually the past resistance will become the future support.

On the graph it looks nice, but what is the logic behind that?

I’ve just gotten a better picture of why that happens … and understanding the why can be very important for understanding more about market sentiment and price actions.

Using the Nikkei 225 as background

So the market I’ve been following the longest since I’ve started investing is probably the Nikkei 225 index.

After it broke through 40k, inched up to 41k briefly but eventually it was a great resistance and it went back down and never went back in the past few months.

Unfortunately I was still a completely beginner and made the mistake of going all-in at almost the highest point due to FOMO.

The reality is, why is there a 40k resistance?

Logic behind resistance

So 40k is a huge mental point for several reasons. The main one is probably the fact that it was the highest point in the last 30 years.

Why does that matter? because people that bought near the highest point can finally sell without realized loss.

Then there’s the point that, because it was the previous high, market participants think that it probably won’t break through, and it become a self-fulfilling prophecy where many people will set a take-profit point at the resistance and MAKE it the resistance.

And then there’s just the fact that, 40k is a nice round number that in people’s mind (say, the general Japanese population) just hard to imagine it becoming. After years of seeing and believing that N225 is in the 20k, 30k … 40k feels like a bubble.

Many people are saying and still saying that it’s a bubble, of course without understanding the fundamentals.

But again if most people think it’s a bubble, then they’ll sell and it strengthen the resistance.

The current resistance

The recent highs are at 39.3k and trying couple times at 38.9k. 38.9k is the 0.618 on the Fib, creating a strong resistance

If I’m looking at the longer term by the way, the 39.5k is the .618 and it has been a great resistance too:

The breakout attempts

However, behind the resistance, things are making progress.

Looking at N225, from April to June the EPS and forward EPS have improved significantly.

The yen has also dropped quite a bit and it should have contributed to extra growth expectations.

So what happens is, the fundamentals are improving, but the market hasn’t caught up because of sentiments and irrationality.

But the fact is, as the fundamentals improve, the buying pressure will build up. The selling pressure will keep fighting it and keep it at the resistance level.

Eventually as the buying pressure keeps increasing and the sellers diminishes, the price starts to try breaking through.

Once it break through a bit though, some final sellers will jump out and stop the buyers from trying – and a few “retries” might happen.

If the buying pressure isn’t enough, those late sellers will win and keep the prices at bay and again struggle up and down for a little bit.

The real breakout

If the fundamentals haven’t changed and the buying pressure keeps building up, then eventually those final sellers will also run dry.

Once the sellers run out to hold up the resistances, the price will break through the resistance by a significant enough amount.

And once that happens, another thing that will happen is the market sentiment will take a 180 degree change.

Remember those people who thought 40k was a bubble? Well now they’ll look like an idiot saying 40k is a bubble when it reaches say, 42k, 43k.

And those people who are looking at resistance levels? Well they can see clearly as night and day that there is no more resistance.

So people who would’ve sold immediately at 40k are pretty much all gone. The people who are trading and dumping at 40k are all gone. But lots of buyers who feel like 45k, 50k is the real value is standing there lining up to buy.

So those people are buying even if the prices are increasing. Those who thought 40k was a bubble now are thinking maybe I need to buy before it goes too high. The traders are seeing it going up with no end in sight and instead of dumping at 40k now they are buying at 40k.

So this will ride up, and it’ll ride up HARD – probably to a point of overbought again.

How to trade based on that

Here is where trading success comes in – realizing the real breakout just a tiny bit sooner than everyone else, and ride that wave up. THEN even when it’s overbought, stay in there because it can stay overbought for quite a while.

Only get out when enough people are also starting to realize it’s overbought and it starts to adjust. Of course success also comes in realizing the adjustment just a tiny bit sooner than everyone else.

Also spotting false breakout (breakout attempts) and staying put instead of going in too early – this one can be hard.

Spotting false ends to the breakout trend is the other side too but that’s actually less important as the wave usually ride pretty hard with everyone going in.

This whole thing can also be applied to the downside as well but it’s more risky trading on the short side I think.

Anyways that’s what I’ve learned in the last few days 🙂