What is market psychology?
Market psychology is a set of ideas that price movements reflect or are influenced by the emotional state of participants. It is also one of the main topics of behavioral economics, or more precisely, its parallel field of research, which examines the factors that precede various economic decisions.
Many believe that emotions are the main factor influencing the price fluctuations of assets at financial exchanges. In turn, fluctuations in sentiment among investors create so-called psychological market cycles.
In other words, market sentiment is the feelings that investors and traders have about the price movements of an asset. When market sentiment is positive and prices are constantly rising, there is a bullish trend (often referred to as a bull market). The opposite situation is a bear market, where there is a decline in prices.
Thus, the general sentiment is the aggregate of the individual opinions and emotions of all traders and investors in a given market. It can also be called the general sentiment of market participants.
But, as in any society, no one opinion is completely dominant. According to the theories of market psychology, the price of assets tends to change in response to the general mood of the market, which is just as highly dynamic. Otherwise, it would be much harder to make a successful trade.
In practice, when the market goes up, it has more to do with confidence among traders and improved attitude to the market. Positive sentiment leads to an increase in demand and a decrease in supply. In turn, increasing demand can provoke an even stronger reaction. Similarly, a downtrend tends to spread negative sentiment, which provokes a decrease in demand and an increase in the available supply of assets.
Changing sentiment during market cycle shifts
Impulse or uptrend
All markets go through an expansion and contraction cycle. When the market is in the expansion phase (bull market), there is an atmosphere of optimism, faith and greed. As a rule, these are the main emotions that influence an increase in buying activity.
Quite often you can see a kind of cyclical or retroactive effect during market cycles. For example, sentiment becomes more positive when asset prices rise. In turn, rising prices affect the impulsive spreading of this trend among all traders, which expands the market even more.
Sometimes the feeling of greed and traders' confidence in the further behavior of the market "inflates" it, due to which the so called "financial bubble" appears. In such a case many investors get into a state of affect, not realizing the real value of the asset and believing that the market will continue to grow at the same rate.
Traders become obsessed with future momentum, hoping to maximize their profits. As the price rises, a local top is created and this is the highest point of financial risk.
In some cases, the market will experience minor fluctuations until the assets are gradually sold off. This situation is called the distribution stage. However, during some cycles there is no clear allocation stage, and the fall of the value may start soon after the maximum price is reached.
Decline (correction, downtrend)
As the market reverses, the euphoria is replaced by a state of complacency - many traders refuse to believe that the uptrend is over. But as prices continue to decline, market sentiment quickly turns negative. This often overlaps with feelings of anxiety, denial and panic.
In this context, we can describe anxiety as a period of time when investors begin to look for motives for price declines, which soon leads to a stage of denial and non-recognition of the current market situation. For this reason, many traders continue to hold their positions at a loss because it is too late to sell assets in the hope that the market will turn around soon.
But as prices fall further, the selling wave intensifies. Fear and panic often lead to market capitulation (when owners give up and sell their assets at an unfavorable price).
Eventually, the downtrend reverses as prices stabilize and volatility decreases. Usually the market experiences sideways movements before there is a sense of hope and optimism. This period of sideways movement on the chart is also known as the accumulation stage.
How do investors take advantage of market psychology?
Assuming this theory is correct, understanding the basics can help traders find the right entry and exit for their trades at the most appropriate time. Because the general attitude of the market is counterproductive, the moment of greatest financial opportunity (for the buyer) usually occurs when most participants are desperate and the market is severely depressed. In contrast, the moment of greatest financial risk often occurs when most traders feel a sense of euphoria and are overly confident of further growth.
Because of this, some traders and investors try to determine the mood of the market and understand which stage of the psychological cycle is occurring at the moment. Ideally, they will use this information to buy assets at a time of general panic (at a low price) and sell at a time of greed (at a high price). In practice, however, finding such optimal entry and exit points is not easy. The anticipated local bottom (support zone) may not hold under the onslaught of sales, leading to even lower lows.
Technical analysis and market psychology
Understanding how the psychology of participants has changed is quite easy after familiarizing yourself with market cycles. Analysis of previous data shows which actions and decisions would be most profitable.
However, predicting future market changes is extremely difficult, and many investors use technical analysis (TA) to anticipate where the market may go.
Some technical analysis indicators are also tools which partly measure the psychological state of the market. For example, the Relative Strength Index (RSI) indicator can indicate when an asset is overbought due to strong positive sentiment and excessive greed. The moving average (SMA) also allows you to determine if an asset is overvalued.
MACD is another example of an indicator that can be used to determine the stages of the market cycle. That is, the correlation between its lines can indicate a change in market momentum (e.g., buying strength is weakening).
Bitcoin and market psychology
Bitcoin's bull market in 2017 is a prime example of how psychology affects the coin's value. From January through December, bitcoin rose from around $900 to its all-time high of $20,000. During the rise, market sentiment became increasingly positive. Thousands of new investors entered the market too late with a desire to capitalize on the bullish trend. FOMO syndrome, excessive optimism and greed quickly pushed the price up until the opposite happened.
The trend reversed in late 2017 and early 2018. The subsequent correction led to significant losses for many late investors. Even when the downtrend was in effect, unwarranted confidence and complacency caused many to keep going.
A few months later, market sentiment turned extremely negative as investor confidence reached an all-time low. Fear, Uncertainty and Doubt (FUD) caused many of those who bought on rising sentiment to sell on falling sentiment, causing large losses. Many became disillusioned with bitcoin even though the technology was essentially the same.
Cognitive distortion
Cognitive distortion is a common pattern of thinking that often leads people to make irrational decisions. Such a pattern can affect both individual traders and the market as a whole. A few popular examples:
- Confirmation bias: the tendency to overestimate information that supports our own beliefs while ignoring or dismissing facts that contradict it. For example, investors in a bull market may pay more attention to positive news while ignoring bad news and signs that a market trend may soon reverse.
- Fear of Loss: It is a common tendency for people to worry more about their losses than about the opportunity for gains, even if the gains are greater than expected. In other words, the fear of loss is usually more painful than the joy of gain. This can cause traders to miss out on a good earning opportunity and a panic-sell in market capitulation is likely to follow.
- The endowment effect is the tendency for people to overvalue what they own simply because of the fact of ownership. For example, an investor who owns a block of cryptocurrency is more likely to believe in its value than a person with no interest in coins.
To summarize
Most traders and investors agree that psychology affects asset values and market cyclicality. While the psychology of market cycles is well known to all, it is not always easy to deal with.
Whether it was the Dutch Tulip Mania of the 1600s or the dot-com bubble of the 90s, even seasoned traders had a hard time separating their own opinions from the general mood of the market. Therefore, investors face the difficult task of understanding not only the psychology of the market, but also their own, as well as the facts and reasons that influence their decision-making process.
Keep your nose to the wind and know that Fortune, Luck and Success
always favor you,
when you are with us!
Always yours C.J.
All the above is not financial advice, but only a subjective opinion of the author. If you doubt something, do your own research and double-check the information yourself.
