Turtle Trading Rules

Chapter 12: Finding Trade Opportunities
Advantage is found on the battlefield between buyers and sellers.As a trader, your task is to find these battlefields and wait and see who wins and who loses.

The trading advantage comes from the differences and cognitive biases of traders, and from the wrong belief of economists that market participants are rational.In reality market participants are not rational.We discussed how cognitive biases create trading opportunities at a theoretical level in Chapter 2.In this chapter, we'll talk about this in more depth with real data.

support and resistance

Support and resistance are a fundamental concept to almost all trading strategies.The so-called support and resistance means that the price has a tendency not to break through the previous level.The easiest way to understand this concept is to look at a price chart (see Figure 6-1).

Support and resistance are derived from market behavior, and these market behaviors are derived from three cognitive biases: anchoring effect, near-term preference, and disposition effect.

Anchoring refers to the tendency to rely on readily available information to judge price levels.A recent new high or low becomes a new anchor against which every subsequent price level is measured and compared.Whether the new price is high or low depends entirely on whether it is above or below this anchor price.Recent highs or lows serve as anchors because they are readily visible on a chart and have a significant psychological impact on market participants.

At the "Support 1" mark, a low around $1.13 immediately became the new anchor, not to mention when the price climbed to $1.20 over the next few days.It is a low point on the chart that stands out to both short-term day traders and long-term position traders.Traders are still eyeing the last recent low at $1.23 as prices bounce back to around $1.15 after peaking around $1.13.At the $1.15 level, they would consider the price lower, but not too low because it is still above the anchor price of $1.13.

Recency bias refers to the tendency of people to place more weight on recent data and experience.When traders judge the current price, since the low of $1.13 is recent, it affects traders more than other previous lows.This near-term low price is all the more important to market participants as a function of near-term preference.So, how does this affect the support and resistance phenomenon?

Suppose you are a trader who wants to buy coffee contracts.When the price has just dropped to $1.13, you may want it to continue to fall, so you don't buy at this price.When the price goes all the way up to $1.23 in the next few days, you start to regret not buying below $1.15, because you have already started to anchor the recent low price of $1.13-this price has become " Low "price reference standard.So, when the price dips below $1.15 a few days later, there is a good chance you could be buying even though that price was there just a few days ago.With the combination of anchoring and near-term bias, you would consider anything below $1.15 to be low and therefore a good time to buy.Since so many market participants see a price below $1.15 as an ideal price, as soon as the downtrend pauses below $1.15, more traders will enter the market immediately.It is the influx of newcomers at the support and resistance levels that makes the market bounce off previous highs and lows.

Most traders believe in the existence of the phenomenon of support and resistance, which further strengthens support and resistance, because traders who believe in this phenomenon, in turn, promote it.If there are many traders who believe that if the price falls to a certain level, there will be a large number of buyers, it is easier for them to believe that the price will inevitably rebound when the price falls to this level.This belief will weaken their willingness to sell at this level, as they would prefer to sell later—once the price bounces off this support level.The belief in the phenomena of support and resistance thus makes it a self-fulfilling mechanism.

The disposition effect refers to the tendency of traders to lock in profits early rather than let them continue to grow.The more profits there are, the more traders fear losing them.How does this affect the support and resistance phenomenon?

Let's say you're a trader who bought coffee at $8 in early August--at this time, the period marked "Support 1.02" has just ended.When the price jumps up to $2 in the next few days, you may not sell because the price has risen so fast that you believe it can continue to rise to $1.14 or $1.20.Then, when the price drops to $1.25, you start to regret not selling at $1.05.At this time, the recent highs have started to affect your thinking, and you will think: "If the price breaks through $1.10 again, I will definitely sell".

So, when the price does bounce back to that level, you sell to lock in a profit.There may be many other traders with similar positions who also want to sell when prices bounce back to these recent highs (the area labeled "Resistance 2").This creates a natural barrier at this level, as at this point many traders want to take advantage of the so-called "high" to get out.Since the high reached in early August became the new anchor against which all subsequent price levels were measured, prices near this anchor were considered high.Therefore, more and more traders are willing to sell when the price is close to these high prices.

Breakout of support and resistance levels
Like many other trading theories, support and resistance is a general concept rather than a golden rule.Prices don't necessarily bounce off previous highs or lows, just tend to do so.The price does not necessarily start to rebound at a certain high or low point precisely, but sometimes it will be a little earlier, sometimes it will be delayed, and sometimes there will be no rebound at all.

If one is using a counter-trend strategy, then support and resistance are the immediate source of advantage.The tendency for prices to bounce off previous highs or lows is where counter-trend traders have an advantage.Countertrend traders relying on this mechanism can make money if support and resistance levels hold.

Conversely, if one is using a trend-following system, the breakout of support and resistance levels is what matters.As an example, consider what happened after a support level was broken in the December 2006 heating oil contract (see Figure 12-6).

In mid-June, support at $6 a gallon was tested for the first time.The price rallied at $2.10 before finding resistance at $2.10 - a new resistance level.After the price bounced off the support at $2.31, the market moved higher again but was still unable to break the resistance at $2.16.Notice what happens when the price falls back down to the level labeled "Support 2.31" again.This time, the downward trend has stalled slightly, indicating that there is some buying pressure, but the position has not been held.The price finally broke below "Support 2" - which was also preceded by several days of gains, suggesting some buying pressure at this point as well.

The most intriguing of all is what happened next—more dramatic given the psychological ups and downs of various market participants. On September 9, the price fell below its previous low and closed below $5. The low of $2.05 was made on August 2.05, just 8 days ago.This means that all traders who were long in the near term (that is, bought heating oil in the hope that the price would rise) lost money.Also, traders have seen no near-term price levels that would hopefully provide a little support, which means that if prices were to drop, it would likely be a big one.As shown in Exhibit 30-3, this was indeed the case - the price plummeted until $6, where there was little buying, perhaps because $2 was a support level established 1.85 months ago.But this line of defense also fell, and the market did not start to recover until it reached a low of $1.85 in late September.

Smart counter-trend traders may have exited before the market closed on September 9, or early the next day.They know that support levels can sometimes be held, but sometimes they can't.If you can't hold on, you'd better not sing against the market, or you will be wiped out by the market.This time is an example.

Suppose you are bullish on heating oil and have bought 2.10 contracts at $5.You might buy 2.05 more contracts when the price drops to $5, as heating oil becomes cheaper compared to the near-term support at $2.10 (anchor).So what do you think when the price goes on to break below $2.00, $1.90, and then a few days later below $1.80?What started as a small deal of 5 contracts has turned into 10 contracts and the loss is now a horrendous $115500 (10 contracts each representing 42000 gallons of heating oil, an average loss of $0.275 per gallon).

This kind of thing is common among novices.When the market swerves and suddenly starts going against them, they panic and find themselves on the wrong side.Trend-followers are on the brink, because they're betting on a continued downtrend, and they keep making money when the market keeps making new lows.

The advantage for trend followers is the cognitive lag when support and resistance levels are just broken.At these times, people are still clinging to old beliefs and are slow to change, so the market is not changing fast enough to reflect the new reality.It is for this reason that the statistical evidence shows that markets tend to coast more after support and resistance levels are broken than at other times.

In the example above, once the price breaks below the initial support level at the end of the "Support 1" level, there will be no new buyers.If you wanted to buy heating oil but the price has dropped below $2.05, would you buy it now?No, you will wait for the market to stop falling.Since the price is still falling, why buy now?But on the other hand, as the market continued to fall, more and more people began to sell in a panic, pushing the price lower and lower.This trend will continue until the sellers run out of energy and some would-be heating oil begins to believe that the price is as low as it can go.

Turtles have seen this happen countless times.There are times when we are building positions, and at these times the market moves that excite us.There are times when we are exiting positions and at such times we, like many other traders, want to exit our profitable positions when the market breaks support.

A breakout occurs when price "breaks through" a previous resistance or support level.As breakout traders, we buy long when resistance levels are broken and sell short when support levels are broken.When the market breaks through support in the short term, we sell to exit a long trade; when the market breaks through resistance in the short term, we buy to exit a short trade.

price instability
I call those price levels near the edges of support and resistance levels points of price instability.At these points, the price is less likely to remain stable and more likely to move higher or lower.If the support holds, the price will move higher.If the resistance level holds, the price will bounce off the resistance level and move lower.Once the support or resistance level is broken, the price will continue to move forward in the direction of the breakthrough, and it will move forward for a considerable distance.If the market breaks through a new price level that has not been seen for a long time, there is generally no obvious follow-up support or resistance point.In the eyes of traders, the obvious anchor is no longer in place, and no potential turning point can be seen.

In either case, prices are unlikely to hold steady.That's why I use "unstable" to describe these points.At these points, the pressure is too great.Eventually one side will win the psychological battle, and when the exhausted side finally gives up, the price will go up or down all the way.Markets generally don't stand still.Points of price instability represent excellent trading opportunities because at these points the difference in price between good and bad trades is relatively small, which means making mistakes is less expensive.

I liken trading to war for another reason.In a typical war, the attacking commander waits patiently for the best opportunity to win.He might send a small raiding force to test the enemy's defenses, but he would not strike at full force until the time came.In the trading market, when the price is between the support and resistance levels, neither the bulls nor the bears are really fighting, so it is difficult to judge who wins and who loses.As the price approaches a support or resistance level, both sides get more involved, and one side always loses.A price breakout battle cannot be both successful and unsuccessful.There are only two possibilities - either success or failure.

The easiest time to judge whether a war is won or lost is when the war is about to end.Similarly, for the psychological battle between the long and short sides at the support level and resistance level, when both sides are putting in their best efforts, it is the easiest time to judge who wins and who loses-at this time, you can see whether the market has broken through support or resistance The level continues to move forward, or it clearly rebounds and reverses at the support level or resistance level.

一个在2.10美元的价格买入做多的反趋势交易者可以设定一个2.04美元的止损退出点，因为这个价位代表着支撑位的突破。类似地，一个在2.10美元的突破位卖空的趋势跟踪者可以设定一个2.15美元或2.16美元的止损点。如果价格在触及2.10美元之后还能够反弹到2.15美元或2.16美元的水平，这说明市场仍然呈现强势，支撑位可以守住。

Cognitive bias has caused traders' systematic misunderstandings, and where there are misunderstandings, you can find trading advantages.These places are the battleground between buyers and sellers.Good traders will see the clues and place bets on the side they think will win.If they make a mistake, they admit it, get out of the deal quickly, and salvage the situation.The following chapters build on these concepts and gradually reveal the complete system.

(End of this chapter)