What is Market Psychology?
Market psychology refers to the belief that market movements are affected or influenced by the emotions of their participants. This topic is a major focus of behavioral economics (an interdisciplinary field that studies various factors that influence economic decisions).
Many believe emotions are the primary driver of shifts in financial markets. The psychological market cycles are created by fluctuations in investor sentiment.
Market sentiment can be described as a general feeling investors and traders have regarding an asset’s price movements. A bullish trend is one that is positive when prices rise continuously. This is often referred to as a “bull market”. A bear market is when prices are constantly falling.
The mood is a combination of the views and emotions of all investors and traders in the financial markets. It can also be viewed as an overall feeling among market participants.
As with all groups, there is no one opinion that is right or wrong. According to market psychology theories, asset prices tend to change based on market moods, which are also dynamic. It would be much harder to complete a transaction successfully.
In practice, a market that is higher will likely be due to traders’ confidence and improved attitudes. Positive market sentiment leads to an increase in demand, and decreases in supply. An increase in demand can lead to a stronger attitude. A strong downtrend can also lead to negative sentiment, which reduces demand and boosts supply.
What happens to emotions during market cycles?
Markets go through cycles of expansion or contraction. Bull markets are characterized by optimism, faith, and greed. These emotions are what usually lead to active buying.
You can often see some sort of retroactive or cyclical effect during market cycles. As an example, positive sentiment increases with rising prices, which causes it to be even more positive and drives the market higher.
Sometimes, a strong sense or greed or faith can take over the market and cause a financial bubble. Investors can become delusional and buy assets just to believe that the market will rise again.
They get greedy and overly stimulated by the market impulse in an attempt to make a profit. A local top is formed when the price rises too much. This is generally considered to be the maximum level of financial risk.
Sometimes, the market may experience sideways movements as assets are sold. This stage is also known by the spread stage. In some cycles, however, there is no clear stage for distribution and the downtrend starts soon after reaching the top.
If the market begins to move in the opposite direction, euphoria may quickly turn to complacency as many traders refuse believe the uptrend is over. Market sentiment quickly becomes negative as prices fall. This can lead to panic, anxiety, and denial.
Anxiety is the point at which investors start to question why the price has fallen. This quickly leads to a stage called denial. A feeling of rejection is a hallmark of the period of denial. Investors will often hold onto losing positions because it is too late to exit or because they believe the market will soon rebound.
As prices fall, so does the sales wave. Fear and panic can lead to market capitulation, when holders sell their assets and surrender to the local bottom.
As volatility declines, the market stabilizes and stops the downtrend. The market will experience sideways movements, which is usually followed by optimism and hope. This lateral phase is also known by the accumulation stage.
How can investors use market psychology to their advantage?
If the theory of market psychology holds true, it is possible to understand it and help trader move in and out at more favorable times. Market psychology is generally negative. The moment of greatest financial opportunity for the buyer is usually when most people feel hopeless and the market’s low. Contrary to popular belief, the moment of greatest financial danger often occurs when market participants are optimistic and confident.
Traders and investors attempt to predict the mood of the market to help them determine its psychological cycles. They would then use this information to purchase when there is panic (lower price) and sell when there’s greed (higher price). However, it is not always easy to determine the optimal price points in practice. Even though it may appear that a local bottom (support), may not be strong enough to support further lows.
Market psychology and technical analysis
It is easy to look back on market cycles and observe how psychology has changed. Analyzing past data can help you understand which actions or decisions are most profitable.
It is more difficult to see how the market changes over time and to predict what will occur next. Investors use technical analysis (TA), to attempt to predict the future direction of the market.
We can think of TA indicators as tools that can help measure the psychological state in the market. The Relative Strength Index (RSI), for example, can indicate that an asset has gone too high due to strong market sentiment (excessive greed).
Another indicator that can be used for determining the psychological stages of the market is the MACD. The ratio between the lines can indicate changes in market dynamics (e.g. purchasing power declines).
Bitcoin and Market Psychology
The 2017 bull market in bitcoin is an excellent example of market psychology and how prices can be affected by it. Bitcoin rose to an all-time high of $20,000. Between January and December, it went from $900 to about $900. The market sentiment grew more positive during the upswing. Bull market hype has attracted thousands of investors to the market. FOMO, excessive optimism, and greed quickly drove up prices until it happened.
The trend shift began in late 2017 and continued into early 2018. Many of the participants suffered significant losses due to the subsequent correction. Even though the downtrend is established, many people continue to HODL despite their false confidence and complacency.
A few months later, market sentiment was very negative and investor confidence reached historic lows. Many of those who purchased near the top were forced to sell at the bottom by panic and FUD, resulting in large losses. Although the technology is essentially the same, some people are disillusioned by Bitcoin. It’s actually constantly improving.
Cognitive biases can be thought patterns that cause people to make irrational choices. These patterns can have a negative impact on individual traders as well as the entire market. These are just a few examples of common patterns:
- Confirmation bias is the tendency to underestimate information that supports our beliefs and ignore or reject information that challenges them. Bull market investors might pay more attention to positive news, but ignore negative news or signs that the trend is changing.
- Loss aversion is a common tendency to be afraid of losses more than profits. Even though the profit may be the same or higher, it’s still a fearful behavior. The pain of losing is often more painful than the joy that comes with gaining. This can lead traders to miss opportunities and panic sell during market periods. surrender.
- Endowment effect is a tendency for people to underestimate what they have simply because they own it. An investor who has a bag of cryptocurrency will be more inclined to believe it has value than one who isn’t involved in monetization.
Most investors and traders agree that psychological factors influence market cycles and prices. While psychological market cycles are well-known, they can be difficult to manage. Even experienced traders had difficulty separating their market sentiment from their own attitudes, starting with the Dutch Tulip mania of the 1600s. It is difficult for investors to understand not only the psychology of market participants, but also their psychological reactions and how they affect their decision-making.